Most of the positive PR about 401(k) plans is warranted: They’re convenient, as contributions are deducted directly from the worker’s paycheck. They enable savers to shield a substantial amount of money from taxation ($18,000 a year; or $24,000 if you’re 50 or older), and if an employer matches a portion of employee savings, it’s an easy way to score free money.
But don’t believe everything you hear. Falsehoods — and even following fact-checked 401(k) rules of thumb in every situation — can steer savers off course. Here are five 401(k) rules worth further scrutiny.
1. A 401(k) should always be the first stop for retirement savings.
If an employer is generous enough to supplement employee contributions, then do not pass go until collecting that free money.
No employer match? Pump the brakes. Maxing out an individual retirement account (either a traditional IRA or Roth IRA) before contributing to the 401(k) may be a better move. In the IRA vs. 401(k) standoff, IRAs win by giving savers access to a broader range of investments and more control over investment fees.
2. The IRS doesn’t allow contributions to a 401(k) and IRA in the same year.
The IRS does allow savings twofers, as well as the ultimate tax-saving triumvirate — contributing to a 401(k), Roth and traditional IRA, as long as you follow IRS contribution and deduction limits.
3. Participation is free.
There’s no cover charge to sign up for a 401(k). But there are costs (deducted annually from an employee’s account) once you’re in the door. The two main kinds of fees are:
- Administrative fees: Most companies hire a 401(k) administrator to handle recordkeeping, compliance, distributions, account statements and the like. The bill for these services is based on a percentage of the assets under management (such as 1% of the amount employees have socked away) or on a per-participant basis (e.g., $150 a year per employee contributing). How much individuals are required to chip in for the bill (all, none or some) is at the employer’s discretion.
- Investment fees: Within the plan, participants must cover management fees — often referred to as the expense ratio — charged by the mutual funds they choose. (Try to stick with funds charging less than 1%.)
4. A 401(k) loan is better than a traditional loan.
Lost opportunity for investment growth is just one reason to ignore the siren song of borrowing money from a workplace retirement plan. A less-considered reason is that you may be overpaying to borrow.
A report from the Journal of Financial Planning found that in a low-interest-rate environment (like the one we’re in), a 401(k) loan is less appealing than borrowing from a bank or other financial institution at market rates. This is especially true on small loan amounts when factoring in origination and maintenance fees because, yes, 401(k) loans often charge those, too.
Then there are the strict 401(k) loan terms: Quarterly payments of principal and interest are required; the loan generally must be paid back within five years; and if you leave your job (voluntarily or not) you’ll need to pay back the loan within 60 days or the amount you borrowed will be taxed as ordinary income and subject to a 10% early withdrawal penalty for borrowers younger than age 59½.
5. Never leave your money behind in a 401(k) after you change jobs
Take it or leave it? The “take it” option using a 401(k) rollover makes sense if the old plan suffers from any of the maladies mentioned above (high plan fees, lack of investment choices). (If your plan forces you to take the money and cuts you a check, just make sure to transfer the money directly into an IRA or a new employer’s 401(k) within 60 days of leaving the company to avoid getting socked with early withdrawal penalties and taxes.)
There are, however, exceptions to this rule. If you’re at risk of being sued or going bankrupt, workplace retirement accounts offer better protections against creditors than IRAs do. Another plus for staying put is that 401(k) withdrawals for those who leave the company at or after age 55 are penalty-free. With an IRA you have to wait until age 59½.
Source: USA Today