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Kiersten Essenpreis for Money

Corporate pensions have been disappearing in the American workplace for decades now. They have largely been replaced by 401(k)s as the primary type of employer-sponsored pension. These accounts are a critical piece of the retirement planning of some 27 million American workers — so it pays to know a little bit about how they work and what you can do to maximize your returns.

What is a 401(k)?

In contrast to a traditional defined-benefit pension, a 401(k) is a defined-contribution account. Companies like these retirement plans because they cost less, but the defined-contribution structure shifts most of the burden of saving onto the employee — and financial planning pros worry that Americans just aren’t saving enough: According to the Employee Benefit Research Institute, the median 401(k) account balance was just $90,015 at the end of 2018.

Most Americans should be saving more than they are, experts say. “One of the biggest mistakes a person can make when it comes to their 401(k) is simply not saving enough,” says Robert Comfort, president of CUNA Brokerage Services Inc., a division of Madison, Wis.-based CUNA Mutual Group. If you’re not doing so already, take advantage of the tax benefits and employer contributions to maximize your 401(k) nest egg.

Advantages of a 401(k)

Enrollment in a 401(k) is easy. In fact, many companies now automatically enroll new workers in their 401(k) plan, requiring those who don't want to participate to actively opt out.

A traditional 401(k) is a tax-deferred retirement plan. (The inelegant name comes from the IRS statute that defines it.) You contribute pre-tax dollars from your paycheck, which you then invest in mutual funds or — less commonly — exchange-traded funds (ETFs) or individual stocks. That money grows and is reinvested, tax-free. Your 401(k) money is not taxed until you take withdrawals in retirement. (A Roth 401(k) is the opposite: you contribute post-tax money then withdraw your funds tax-free in retirement.)

Young workers in particular should be putting away as much as they can, says Kenny Polcari, managing partner at Kace Capital Advisors, based in Boca Raton, Fla. “Start investing early to take advantage of compound interest,” he says. “Delaying your decision to contribute to your employer's 401(k) plan can cost you big over time.”

Paying taxes on withdrawals in retirement is preferable for most Americans because they will have less income — and consequently fall into a lower tax bracket — in retirement than during their career. Contributing pre-tax income also lowers your taxable income during your years in the workforce, which can reduce your overall tax burden.

One big advantage many employers — especially larger ones — offer is a pre-tax match up to a certain percent of the employee’s contributions. According to Fidelity, that amount averaged roughly 4.5% at the end of 2019. That means your employer puts an amount equivalent to 4.5% of your paycheck into your 401(k) if you put in at least the same amount. In these instances, 401(k)s act as contribution plans that receive both worker and employer funds.

Comfort recommends aiming to save 15% of your paycheck, but if that's a stretch it’s better to start below that in order to get the company match than not save anything at all. “At the very least, begin by deferring enough to receive any company match that may be offered,” he says.

Of note: Before you can access the employer matching funds, companies generally require workers to be “vested.” That is, you must remain with your current employer for a set period of time before you own the matching funds in your 401(k).

How to invest 401(k) funds

The self-directed nature of 401(k) retirement plans means that, while an employer or plan administrator might offer some advisory services to workers, choosing investments and determining asset allocations over the course of your career is largely a DIY task.

Most of the investment offerings in 401(k)s are mutual funds, each comprising a basket of stocks or bonds. Some 401(k) plans also give workers the option of investing in ETFs. Although more liquid than mutual funds (because they are traded throughout the day rather than just once at the end of the day), ETFs can also be more volatile. Many 401(k) investment offerings are index funds, which are designed to track the performance of one of the major market indices.

Experts say your asset allocation should include both stocks and bonds. “Broadly speaking, the younger you are, the more aggressive you can be by having a larger percentage of your 401(k) balances in stocks,” Comfort says. Young adults can absorb more volatility than someone close to retirement, he says. “They have many years before retirement to ride out the inevitable ups and downs of the market.”

Your asset allocation should grow more conservative over time. “As you move into your 60's, you want to re-allocate more money into bonds and into large blue chip stocks, ETFs or mutual funds that pay high dividends. These kinds of stocks offer some growth, but also income through the dividends,” Polcari says. “As you get closer to retirement, you may not want as much exposure to growth stocks — which can be more volatile — than dividend stocks, which tend to be more stable.”

If you don’t want to manage these reallocations yourself, you can invest in target-date funds, which automatically adjust to become more conservative the closer you get to retirement.

The other important part of the equation is how much a particular fund charges in fees. Competition between financial services providers has driven down fees on mutual funds and ETFs, but that doesn’t mean fees have vanished entirely. “When it comes to 401(k) investing, be mindful of the fees that each fund in the 401(k) has. Fees can eat away at investing returns over time,” Polcari says. While you may not have much say over the menu of investments in your employer's plan, you can at least be mindful of individual fund fees so you can pick the lowest-cost options among them.

Contribution limits for a 401(k)

The maximum you can contribute to a 401(k) throughout the year is revisited annually by the IRS. The contribution limit for 2021, though, is the same as this year’s: $19,500. The IRS permits workers aged 50 and older to contribute additional “catch up” funds; for next year, that number also remains at the 2020 level of $6,500. If you haven’t contributed as much to your 401(k) as you should have when you were younger, or if you realize you’ll need more spending power in your later years, catch-up contributions can be a good way to plug that hole.

How to withdraw money from a 401(k)

You can begin taking penalty-free distributions from your 401(k) at the age of 59 ½. At the age of 72, you are mandated to take required minimum distributions (RMDs) from your 401(k) account (although you may qualify for an exemption from taking RMDs from your current 401(k) if you are still working.) The amount of your RMD is calculated using the value of your account balance and actuarial estimates of your life span.

Outside of certain exemptions, if you withdraw money from your traditional 401(k) when you are younger than 59 ½ years old, you will trigger an early withdrawal penalty of 10%, and that money will be taxed as ordinary income on top of that. In addition, you lose the opportunity for that money to grow. For these reasons, financial advisors dissuade people from raiding their 401(k) early.

How to roll over a 401(k)

If you change employers and your new employer has a 401(k) plan for which you are eligible, you can roll over your funds into the new plan. It is preferable to do this as a direct transfer of funds rather than requesting a check, because if you take longer than 60 days to complete the rollover, the IRS will treat it as an early withdrawal subject to taxes and penalties.

When you retire, you will need to decide if you want to keep your money in your former employer’s 401(k) or roll it over into an Individual Retirement Account (IRA). “It’s important to weigh this decision carefully, as there can be pros and cons to each option,” Comfort says. An IRA may offer you more varied and more flexible investment options, including access to alternative classes that aren’t generally well-represented in 401(k) plans. If you worked for a big company, though, it might be worth staying with that 401(k), where you’re likely to have access to low-cost investment options.

If you worked for multiple employers over the course of your career and kept each respective retirement account where it was, rolling them all over into a single IRA could consolidate your financial planning and give you a better snapshot of your financial health.

Can you start at 401(k) without an employer?

These are employer-sponsored accounts, so you can't open a 401(k) on your own. If you find yourself in a job that doesn't offer a 401(k), open an IRA and contribute to that. However, if you are self-employed, you can look into opening a one-participant 401(k) plan, also known as a Solo 401(k).

About Roth 401(k)s

Roth 401(k) are different from their conventional counterparts in that they are funded with after-tax, rather than pre-tax, dollars. The money then grows tax-free, and you don’t pay taxes on withdrawals in retirement. (Money that is contributed by your employer, though, is taxable upon withdrawal.) Experts say Roth 401(k)s can be a good option for younger workers, since younger workers presumably haven’t reached their peak earning years and are more likely to be in a lower tax bracket than they will be later in life.

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