Your 401(k). Yes, that vague retirement plan that does who knows what. It is a powerful wealth building and estate planning tool, but it must be utilized properly. Here are 3 tips to optimize your 401(k).
Key points
- Contribute at least 10% of your salary to your retirement.
- Traditional 401(k)s give you immediate tax benefits, but less flexibility. Roth 401(k)s give you long term flexibility and delayed tax benefits.
- Target date funds are the “set it and leave it” option. Managing it yourself can be cheaper but time consuming.
- You can roll old accounts into your current plan or into an IRA.
Contribution Amount
While everyone’s needs are different, the bare minimum should almost never be seen as the automatic enrollment amount (usually 3% of your pre-tax salary). You want to contribute at least enough to receive your full employer matching amount. For example, if your employer is matching you up to 4% of your salary, your minimum contribution should be 4% as well. By doing so, you are effectively doubling your money by contributing the matching amount.
That being said, doing the bare minimum is not likely to set you up for the retirement you dream of. We suggest that you contribute 10-15% of your salary towards retirement and long-term investment goals.
Traditional 401(k) vs Roth 401(k)
If you do not know which of the two plans you have, it is most likely that you have a Traditional 401(k), because plan providers use this as the default option.
The two options can be summarized by the following: A traditional 401(k) gives you the tax benefits upfront but offers less flexibility in the long run. A Roth 401(k) gives you more flexibility but delays your tax benefits. See below for all the similarities and differences between a Traditional 401(k) and a Roth 401(k), and a calculator that estimates which type of account would benefit you most in the long run.
Similarities:
- Contribution limit: $22,500 (additional $3,500 for ages 50+).
- 10% penalty for early withdrawals.
- Qualified withdrawals begin at age 59 ½.
Differences:
- Roth 401(k)
- After tax contributions
- Qualified withdrawals are tax free.
- Required 5 years until withdrawal.
- Can withdrawal contributions without penalty (after 5 years)
- No RMDs
- Traditional 401(k)
- Pre-tax contributions.
- Fully taxable withdrawals.
- Must begin taking required minimum distributions (RMDs) at age 73.
Click Here for a calculator that estimates whether a Traditional 401(k) or Roth 401(k) will save you more money.
What are you invested in?
The default option for many retirement plans is to use “target date funds.” These are managed funds that move from higher to lower risk as you move closer to your retirement date. The other option is to manually select the investments to create your own portfolio. This is a much more time intensive approach; however, you may get the benefit of reducing fees in your portfolio. If you choose this route, be sure to incorporate fees, your risk tolerance, and your time horizon into your decision making. You will want to check with your plan provider to see what investment options are made available to you.
Keeping track of old 401(k)s
No one will move your 401(k) for you, but you have the option to bring it with you wherever you go. Whether you retire, or switch careers, the money can follow you. Here are the most typical options:
Old Traditional 401(k):
- Rollover into IRA
- Or rollover into current employments 401(k) plan.
Old Roth 401(k)
- Rollover into Roth IRA
- Or rollover into current employments Roth 401(k) plan.
Typically, an IRA/Roth IRA gives you more flexibility in your investment options. In addition, you may be able to save on fees. On the other hand, rolling old 401(k)s into your current one often makes it seamless and easiest to keep track of.
For a complimentary assessment of your 401(k) plan, or to discuss what options may be best for you, click here!
Disclosure:
Withdrawals from a Traditional IRA prior to age 59 ½ will be subject to ordinary income tax and may also incur a 10% penalty tax unless an exception applies. You may take nontaxable withdrawals from a Roth IRA if you are at least 59 ½ and the account has been held at least 5 years. Otherwise, earnings withdrawn may be subject to ordinary income tax and a 10% penalty. This is meant for educational purposes only. Information presented should not be considered investment advice or a recommendation to take a particular course of action. Always consult with a financial professional regarding your personal situation before making any financial decisions.