Most folks have heard about a 401k, and many are enrolled in workplace 401k plans. But if you only have a passing familiarity with 401ks, you might be surprised at some of the details not commonly appreciated. For example, here are 10 things you might not, but should, know about a 401k:
1.One Plan, Two Accounts
Most of the money contributed to 401k plans go into traditional accounts, in which you can contribute pre-tax dollars now and pay taxes later, when you withdraw the money. However, many employers provide an optional second account, a Roth 401k. Much like a Roth IRA, a Roth 401k account accepts post-tax contributions that grow tax-free. If you follow the rules, you can withdraw the money tax-free as well. If offered, you can split your contributions between a traditional and Roth 401k in any ratio you want.
2. Early, Penalty-Free Withdrawals Are Available
You are subject to a 10 percent penalty when you withdraw funds from your 401k before age 59-½. However, there are several ways to circumvent the penalty:
- You can begin taking penalty-free withdrawals at age 55 if you leave your job.
- You can set up substantially equal payments that can start paying you a penalty-free annuity at any age. The amount you can receive depends on the guidelines, your age and the account balance.
- Early withdrawals can sidestep penalties if used for certain specific purposes. For example, there are no penalties for money you withdraw to pay for a permanent disability, medical expenses exceeding 10 percent of your adjusted gross income or if you are called to active military duty.
- In a Roth 401k, you can withdraw contributions tax- and penalty-free at any time. However, you will be hit with both taxes and penalties if you withdraw earnings during the account’s first five years. You will also be taxed and may be penalized for earnings withdrawals before age 59-½ unless you qualify for a penalty exception.
Because different solutions are better for different scenarios, it’s always wise to discuss your plans – and your options – with a financial advisor before making a costly mistake that may not be able to be undone.
3. You Can Borrow Money From Your 401k
Unlike an IRA, you can borrow money from your 401k if your plan allows it – but not all plans do. You can borrow a maximum of $50,000 or half the balance, whichever is less. But you can borrow up to $10,000 even if that is more than half of your balance. You then must repay your loan, with interest, within five years or the unpaid balance will be treated as a withdrawal. However, you can take up to 15 years to repay a loan used to pay for your first home. The interest you pay, minus fees, is to yourself and goes back into your account.
Again, make sure you discuss your plans with a financial advisor to avoid any mistakes.
4. Roth 401k Required Minimum Distributions (RMDs)
A traditional Roth 401k requires that you begin taking RMDs after age 70-½. However, unlike a Roth IRA, which has no RMDs, a Roth 401k has the same RMD rules as does the traditional 401k. RMDs are based upon your life expectancy and account balance. If you have a Roth 401k and would like to avoid RMDs, you can roll the balance tax-free into a Roth IRA. Of course, you can also avoid traditional 401k RMDs with the same rollover, but you will have to pay taxes on the full rollover amount.
5. Postponing RMDs
There is an exception to the rule that you must begin taking RMDs from your 401k after age 70-½. You can postpone 401k RMDs (and continue to make contributions) for as long as you are employed. This is different from a traditional IRA, which allows no such postponement. One caveat: This exception doesn’t apply to self-employed individuals.
6. Protection from Creditors
Generally, 401ks offer better protection from creditors than IRAs do. For example, if you are bankrupt, a creditor might be able to attack your IRA for payment, but your 401k is immune. The difference is that 401ks are governed by the Employee Retirement Income Security Act of 1974 (ERISA), while IRAs aren’t. ERISA offers broad protections to individuals enrolled in qualified plans like 401ks, although creditor protection does not extend to 401k beneficiaries. Contrast this to IRAs, in which each state’s bankruptcy laws determine an IRA’s vulnerability to creditors. In some states, the first $1 million in an IRA is protected, with other states offering more or less protection. Many states offer no creditor protection for Roth IRAs.
7. Spousal Rights
You spouse is automatically the beneficiary of your 401k. This is true whether you name your spouse, another person or no one on the beneficiary form. In fact, if you want to name a 401k beneficiary other than your spouse, you must get written agreement from your spouse. That’s different from an IRA, which allows you to freely name beneficiaries.
8. Investment Options
Many workplace 401ks limit your investment choices to a few options, such as a set of mutual funds for stocks or bonds. However, some employers provide self-directed 401ks, which allow you to invest in virtually any asset. If you are self-employed, you can also make your Solo 401k self-directed. With a self-directed account, you might need multiple, specialized custodians for alternative assets, such as real estate and precious metals. However, you cannot transact with disqualified persons, engage in self-dealing or lend money to others from a 401k, whether self-directed or not.
The ultimate size of your 401k nest egg might depend greatly upon the fees you pay. High fees can significantly drain your 401k, leaving less for you when you retire. Your employer must disclose all the administrative fees you pay for your 401k, and investment companies and brokers are supposed to disclose their fees as well. If you feel your employer 401k plan locks you into high fees, talk with a financial advisor about rolling it over to an IRA, which generally have low administrative fees and provide access to low-fee investments.
10. Contribution Limits
Another thing you may not know about a 401k is they have significantly higher contribution limits than IRAs do. For 2019, the limit on annual employee contributions is $19,000 ($25,000 if age 50 or older). You employer can also contribute to your 401k, subject to limits. The sum total of all contributions to your 401k in 2019 is $56,000 ($62,000 if age 50 or older).
Planning for retirement and becoming one of the successful retirement investments stories you hear about can be complex. If you’re ready to seek help, contact Global View to see if we’re the right fit for you.