If you don’t understand how the 401(k) plan works at your company, it’s your own fault. Ouch, sorry if I hurt your feelings there but own up to it!
I know you want to blame your HR department or your plan’s administrator for not educating you. But, the responsibility to learn about and make sure you take full advantage of your plan is ultimately on you! If you make mistakes like not contributing enough, investing in the wrong funds for your risk tolerance and age, and not taking full advantage of the company match, you may have to live with that regret for a long time.
You can stop the bleeding and get back on track. Here’s a primer on the most essential parts of how 401(k)s operate.
It’s hard to believe, but some of us grew up in a time when there was no Google. Way back then, 411 was who you called when you needed information. Like you couldn’t remember the phone number for the pizza joint up the street. You call 411 and they give you the number (or dial it for you for a fee!)
GET YOUR FREE MONEY!
One of the biggest perks of contributing to your 401(k) is the company’s offer to match a certain percentage of your contributions. Most employers (but not all sadly) will provide a match of some kind.
For example, let’s say you make $50,000. If you contribute, say 10% of your pay, that would be $5,000 a year. If your company matches 100% of 5%, then they would give you half the amount you put in (100% of 5% of $50,000 = $2,500). At the end of the year, your 401(k) would have $7,500 in new money deposited. $5,000 of your money and $2,500 of your company’s money. Companies do not need to make their match 100%. They may choose 75%, 50%, 25%, or even 10% of the amount you put in. The overall average across most American companies is somewhere around 3% or 4%. If you get a match of 8% or 10% you are very, very lucky – don’t blow it.
Other than hoping to attract good workers, the main reason companies offer matching contributions to 401(k) plans is they get a tax deduction, the same as you do. Therefore, they can act like they are paying you more money overall, but it helps them pay less taxes by directing some of your income into your retirement account instead of paying you cash.
If you do not recall what your company match is – please email or call your HR department immediately or login in the company’s website to read the benefits information if it’s detailed there.
Sometimes your company does not give you an outright match but instead does something call profit sharing. This is usually tied to company performance and you may not find out what the amount is until the end of the year when they dole it out. It’s even possible to get both company match and profit sharing! Again, check your plan details to find out what’s available to you so you can get every penny of it.
OKAY, HOW IS THIS FREE MONEY GIVEN TO YOU?
Your company can set up their matching rules in a number of ways. These days it’s common to see employers either give you the match throughout the year with each paycheck or they may only deposit it once a year or once a quarter. You want to know this too so you can plan accordingly (especially if you are entertaining the idea of leaving the company soon).
By the way, the IRS says that employers can only match up to a certain level of earnings each year. In 2016, the maximum earnings are $265,000. If you make over this amount, don’t expect those earnings to be matched.
YOU ONLY GET TO KEEP THE MATCH IF IT’S VESTED
Some companies may not entitle you to the money they have matched until you work there for a certain number of years. This is commonly referred to as vesting and the vesting rules can vary too. Some plans make all matching contributions immediately vested. This means you can never lose them. However, if your company vests over a period of a few years, you may get part of the match, or none if you leave before you are 100% vested.
KNOW THE NITTY GRITTY
If you can’t answer these questions, it’s time to find and read your plan’s Summary Plan Description (SPD).
- Can I change my contribution at any time or only during special ‘windows’?
- Are bonuses eligible for company match?
- Do I get match on over-time pay, too?
- How can I update the beneficiary designation for my account?
- Can I divert some of my contributions to a Post-Tax or Roth option? (we will discuss this more in a future post)
THEY TOLD ME I WAS AUTOMATICALLY ENROLLED, SO I’M GOOD RIGHT?
A few years ago, plans were allowed to adopt what’s called Automatic Enrollment. The idea was that we Americans are so bad at managing our finances, that your employer can now sign you up to alleviate you of the whole ten or fifteen minutes it may take you to do it on your own. Man, they are really helping you out. I hope you sense the sarcasm there.
It sounds good that more employees are signed up, right? Well, actually many studies have been done to show that employees who defer this decision to their employers make two terrible mistakes that perpetuate themselves in the long-term. And overall the use of Automatic Enrollment actually drags down the average participation rate after 3 or 5 years of implementing it. Why is that?
- You accept the automatic enrollment percentage and never increase it. Many companies will auto-enroll you in say 3%. What if your company match is up to 5%? You don’t get the match on those extra 2%. Maybe you would have chosen 5% or 10% or even 15% if you had enrolled yourself?
- You are invested in what’s called a Qualified Default Investment. This is usually an ultra-conservative fund or a Target Date Fund which matches investment risk with your anticipated retirement age. There may be lower-fee investment choices, or funds more suitable for your overall investment strategy available. However, you deferred the decision to them.
Don’t defer. You decide how much to invest and where to invest these funds!
PEOPLE MAKE REALLY BAD CHOICES ALL THE TIME IN THEIR 401(k)
401(k) plans were intended to give employees more choice and control over their own retirement savings. However, people make really bad choices all the time. Here are a few of the worst offenders:
- Investing all your 401(k) money in your company stock. Your employer is already your main source of income, right? You need that income to live today. Do you really want to invest your future financial wellness on the same company? Go Google Enron and then come back.
- Don’t take the time to understand the fund choices so you pick the one with the fanciest sounding name.
- Don’t review and consider investment fees. These can really suppress your return over your investment lifetime.
- Taking loans from your 401(k). One of the worst things you can do! Here is a list of reasons why this is a terrible idea:
- You pay yourself back with after-tax dollars.
- You may be able to get a better interest-rate elsewhere if you really need to borrow the money.
- Your money is not working for you and growing while it’s outside the plan.
- You are borrowing to buy something stupid like a new $50,000 truck when this is beyond your means.
- Your company can terminate you or be sold at any time. If you have an outstanding loan when your employment ends (for any reason) you have to pay the loan back in full. Can’t? Then the IRS treats the unpaid balance as a distribution. You’ll have to pay income taxes, plus a 10% penalty if you are under age 59.5. You probably have little control over whether your company fires you, puts you on furlough, or sells the company, so this should be very unsettling.
- Taking a hardship withdrawal. Okay, there are times of serious financial stress when taking money out may be the last option to prevent from filing for bankruptcy or to avoid eviction or foreclosure. But if you can follow simple budgeting skills and spend less than you earn, you should avoid finding yourself in this situation to begin with. Taking a hardship prevents you from contributing for the next six months so you miss out on the company match during this period.
- When switching jobs, doing a rollover to the new plan no matter what. Hmmm, maybe your new employer has fewer employees, a smaller 401(k) plan and really high investment fees? Maybe they have terrible fund options? You have two other choices when you switch jobs. You can leave the money in your old 401(k) plan or rollover to an IRA with any institution you choose.
- Draining your entire account when you leave. As long as your account is over $1,000 and the plan is not being terminated (forcing you to take a distribution or do a rollover), you should be able to park your funds and keep them invested with your former employer until you are ready to withdraw the funds in retirement (or subject to those Minimum Required Distributions [MRD] which occur at age 70 ½). These are funds for your retirement, not for any other purpose. Hands off!
401(k)s come in all shapes and sizes. But the basic mechanics are all the same. You put your hard earned money in. Your employer puts money in. You invest wisely. You pay attention to fees. You don’t take the money out before you retire. You bump up your contributions to the max every year.
Nice. You’re on your way to financial independence and a secure retirement.