Looking to get smarter about your 401(k) plan? We’re here to help with advice you can trust will set you up for a happy retirement in the future.
If you work for an employer that offers a 401(k) plan, good news - retirement planning experts consider traditional and Roth 401(k)s excellent choices for retirement savings. Not only do each offer unique tax advantages, both allow you to select from a variety of investment options. Regardless of which plan your employer offers, or which you choose as someone who is self-employed, you’ll be making a wise choice to participate.
Let’s take a look first at how traditional and Roth 401(k)s differ and the advantages of both.
The Traditional 401(k) vs. The Roth 401(k)
Make no mistake, these are both excellent retirement plan options, and you should participate if you’re eligible and given the opportunity. Both offer unique tax advantages, but the basic difference between a traditional and a Roth 401(k) plan is when you pay taxes.
With a traditional plan, you make contributions with pre-tax dollars, so your tax break comes upfront, helping to lower your current income tax bill. Your money—both contributions and earnings—grows tax-deferred until you withdraw it from the plan. At that time, your withdrawals are considered to be ordinary income and you have to pay federal income tax at the current rate. You’ll also want to check if you’ll need to pay state income tax on the withdrawals.
With a Roth 401(k), it’s basically the reverse. Your contributions are made with after-tax dollars, which means there is no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free at age 59 ½, as long as you’ve held the account for five years.
A tax deduction may seem like a pretty good idea now, but it’s smart to plan ahead. Under today’s rules, each dollar you withdraw from a traditional 401(k) could be reduced 20-30% when you retire, depending on your tax bracket. That means you’ll have to save that much more to fund your retirement cash flow.
Six Ways to Get the Most Out of Your 401(k)
1. Don't Accept the Default Contribution Percentage
Most employers will set you up at the default rate of 3% when you enroll in their 401(k) plan. While this is an excellent place to start for many people, it will help you accumulate more money faster if you contribute a higher percentage of your pay. With a traditional or a Roth 401(k), you can contribute any percentage of your salary you'd like, up to a maximum annual contribution limit set by the IRS. This limit is subject to change each year, so consult the IRS website for the current annual figures.
2. Take Advantage of the Employer Match
The most common employer match is 50 cents for each dollar contributed—up to 6% of pay. Despite what your employer is matching, aim to contribute at least that specific percentage to your plan. It will make a big difference for your account balance in the years ahead. For example, employees of Teachers Federal Credit Union receive a match of up to 50% for the first 5% of an employee's contribution in their 401(k).
3. Stay Until You're Vested
To reduce employee turnover, some employers will configure the plan to penalize you for leaving their company before a stated number of years. If this is the case with your plan, carefully calculate how much money you'll be leaving behind if you quit before you're 100% vested, and if making the change is worth it. A lateral move may end up costing you more than you thought.
4. Don't Cash Out Early
If you wind up changing jobs, as most workers do several times throughout their careers, you’ll have to decide what to do with the money you accumulated in the 401(k) plan from your previous employer. It can be tempting to cash out and spend the money. However you’ll not only end up paying taxes and penalties on it, but you'll also be losing out on the compound interest it could be generating for you.
An alternative is finding out whether or not you can leave the money in your former employer's plan. While you won't be able to contribute to it, you won’t be tempted to spend it. Another option is to rollover the 401(k) balance from your former employer’s plan to one with your new company.
5. Diversify Your Investments
One of the biggest mistakes you can make when choosing how to allocate the money in your 401(k) is putting all of your eggs in one basket. Many people will look at the mutual fund with the largest percentage gain in the past year and put 100% of their money in that fund. This is a choice that often backfires.
For example, let's suppose that a mutual fund composed of technology stocks has performed exceptionally well in the past year. If you choose to invest all of your money in that fund, and tech stocks fall out of favor, your mutual fund could suffer steep losses, and you could erase previous gains.
On the other hand, if you had spread out your investments in a technology mutual fund, an international fund, and an energy fund, you may have avoided a total loss because the other funds had positive gains. Diversification is the key to consistent growth.
6. Take Your Money Out When Required
After you turn 72, you're required to take money out of your plan each year. If you fail to do so, you'll be penalized 50% of the amount you should have withdrawn. Make sure you take the required amount annually from the account. You'll still be able to leave some money in the plan and have it grow.
By following the tips above, you can rest assured you’re wisely getting the most from your 401(k) plan and setting yourself up for a financially secure future. Should you have any further questions, get in touch with the Teachers Trust & Financial Services Team who is available and ready to help.