When planning for retirement, the truth is that the earlier you start saving and investing, the better off you’ll be, thanks to the power of compound interest. A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. In a Roth 401(k) plan, withdrawals can be tax-free.
There are two basic types of 401(k)s:
- Roth— these differ primarily in the way they’re taxed.
In a traditional 401(k), employee contributions reduce their income taxes for the year they were made, however, withdrawals from the 401(k) are taxed. With Roth, employees make contributions with post-tax income, but withdrawals tax-free.
At a time when most people don’t have a traditional pension, growing and protecting your 401(k) balance is essential for a secure retirement. Therefore, pay close attention to 401(k) rules.
When an employee leaves a company where they have a 401(k) plan, they generally have four options:
- Withdraw the money
- Roll it over into an IRA
- Leave it with the old employer
- Move it to the new employer
Try the following strategies to help your 401(k) account grow and to minimize the risk of 401(k) losses:
1. Don’t Accept the Default Savings Rate
New employees are increasingly likely to be automatically signed up for a retirement account at work, most often by having 3% of their pay deposited in their company’s 401(k) plan. But saving 3% of your salary, while certainly better than no savings, may not be sufficient to maintain your current lifestyle in retirement.
2. Get a 401(k) Match
The most common 401(k) match is 50 cents for each dollar saved on up to 6% of pay.If your employer matches your contributions, be sure to take full advantage of this free money that provides a nice boost for your retirement savings.
3. Diversify With a Roth 401(k)
A growing portion of employers now offer a Roth 401(k) option in which workers can save after-tax dollars, and pay outs are tax-free in retirement. A Roth 401(k) generally offers the biggest benefits to young and low-income workers who expect to be in a higher tax bracket later in their career, but it can also add tax diversification and flexibility to the portfolios of people closer to retirement.
4. Think About Your Current Tax Rate and Future Taxes
Pre-tax contributions to 401(k) plans provide an immediate tax benefit. The size and significance of this tax break depends on your marginal tax bracket. You can estimate the amount of tax savings you will see as a result of pre-tax contributions using tools like this Pre-Tax Savings calculator.
5. Avoid Early Withdrawals
Most workers switch jobs several times over the course of their career, which means they need to decide what to do with the 401(k) balance at their former employer. It may be tempting to take an early withdrawal, but the long-term consequences are often not worth it. 401(k) withdrawal rules can be complicated and there are certain situations where penalties can be avoided. However, if you leave an employer or encounter financial hardships, it is often recommended to avoid early withdrawals from a 401(k) plan.
Early withdrawals also cause you to miss out on valuable compound interest that is essential for building a large nest egg. “This money needs to be put away for retirement, and that’s all it needs to be used for,” says Carolyn McClanahan, a certified financial planner for Life Planning Partners in Jacksonville, Florida.
6. Rollover Without Fees
When you change jobs, you can generally leave your 401(k) balance at your former company or roll it over to an IRA or your new employer’s 401(k) plan. If you decide to move your money, ask your former employer to directly transfer the balance to the new financial institution instead of cutting you a check, which will help you to avoid taxes and penalties.
7. Create an Action Plan for Retirement
In order to get the most out of your 401(k) plan, it is important to have a clear vision of why you are saving for retirement in the first place. We all have our own unique definition of what the word “retirement” actually means. If you want to make sure you are making the smartest choices with your 401(k), take some time to assess your goals and review how many of the seven steps mentioned above you have already taken. This assessment will help in giving you a brief assessment of where you stand.