For more than 30 years I have helped employees from companies like Apple, IBM, AT&T and John Deere with their 401ks. I have found that some of the 401k plan questions employees have pop up frequently. You probably have the same questions about your plan.
Following are the top 10 401k plan questions I receive along with answers.
1. How much should I contribute?
This is one of the easier 401k plan questions to answer. Studies indicate that American workers should be adding at least 15% to their 401k accounts each year. Savers who commit to this level of contributions can expect to build account balances at retirement allowing them to retire without reducing their standard of living.
Want to live better in retirement or retire early? Save more.
2. What should I invest in?
Nearly all 401k plans provide participants with at least one option to obtain investment advice at no cost. Either participants have access to the investment adviser working with the plan, robo suggestions based on an algorithm, or a platform like Financial Engines.
Use whatever method you have available to generate an initial recommendation that will be based on your age, gender and ability to bear risk. Make adjustments to the recommendation until you feel comfortable with your allocation. Then stick with it, whether the market goes up or down!
3. What type of contributions — traditional pre-tax 401k or Roth 401k — should I make?
Roth 401k contributions are made after-tax while traditional 401k contributions are made pre-tax. So there is no immediate tax benefit from making Roth 401k contributions. However, there may be huge tax benefits at retirement.
If a Roth 401k contribution account has been in existence for five years or more and if funds are withdrawn due to retirement, the entire account balance may be distributed tax-free.
Whether a Roth 401k contribution strategy will be more tax-efficient than making contributions pre-tax is unknown, since the answer depends upon future tax rates.
As a result, I believe everyone should be splitting 401k contributions between their traditional pre-tax 401k and Roth 401k accounts. The real question is what the split should be, and that is dependent upon the contributor’s age.
I believe individuals in their 20s should make 100% of their 401k contributions to Roth 401k accounts for as long as they can — their entire careers if possible. The opportunity to build a huge, tax-free balance is just too good a deal to pass up.
Conversely, everyone in their 60s and 70s, because of their higher tax rates and fewer years to retirement, should probably make the majority (80% to 90%) of their contributions to traditional pre-tax 401k accounts to take advantage of the immediate tax savings.
All ages in between will benefit from a split that is close to 50/50.
4. How do I know if I am on track?
Virtually all 401k plans have a feedback system to let participants know how they are doing with their savings plan.
Some 401k plans use color coding (red bad, green good), some display projected income replacement ratios on participant statements and nearly all have tools available on a website that participants can use to model different savings and investment rates.
To find out which approach your plan uses, visit your plan’s website.
5. Is my 401k plan a good one?
Maybe. There are seven factors that I recommend using to determine whether your 401k plan is one of the best. They are:
1. Availability of low-cost (non-index fund) investment options.
2. Prevalence of index funds.
3. Availability of investment advice.
4. Availability of projection tools.
5. Feedback on how you are doing.
6. Senior management’s support for your plan.
7. How well you understand your plan.
6. Should I take a 401k loan?
No, never. It is probably the worst investment you can make.
Plan participants are seduced into taking 401k loans by two factors: 1. It is easy (the plan can not reject your loan request because there is no underwriting), 2. Participants are in love with the concept of paying interest to themselves. Let’s look at why both of these factors are bad.
Many plan participants who should not be taking a loan, because of their financial condition, end up taking 401k loans. The 401k plan often becomes the lender of last resort. This only makes their bad financial situation worse.
Gambling (or other) addiction and need some cash? Please don’t take a 401k plan loan. Want to take that dream vacation, buy a new car or boat? Please don’t get the money from your 401k plan. Trying to avoid bankruptcy? Please, please don’t take a 401k plan loan. Your balance is protected from attachment by creditors in the event of your bankruptcy and should only be used for your retirement!
Every time I talk with participants about 401k loans, they mention the tremendous advantage they see of paying interest to themselves.
Couldn’t be further from the truth.
Once you take $10,000 for a loan out of an investment that was earning 12% you turn it into an investment that now earns 5% or 7%. That’s right, your loan is part of your 401k plan account investment portfolio. The interest you pay is what that $10,000 investment now earns. Should you feel good about paying a low interest rate?
And finally, the interest on a 401k loan is not tax-deductible. There are still ways of generating tax-deductible interest payments from a home-equity loan. It is worth looking into.
7. Should I roll over prior employer 401k plan balances?
Yes, but not into a rollover IRA. Roll it over into your current employer’s 401k plan. Your costs will be much lower.
Your prior employer 401k plan balances are likely invested in very low-cost institutional or R6 mutual fund share classes and you can get investment advice for free.
The broker that is calling you to get you to roll over your account balance will likely charge you 1% for investment advice and invest your balance in retail share classes costing twice as much as the institutional or R6 share classes.
Broker rollover IRA sales practices are under investigation by the Department of Labor. I wonder why.
8. Can I get my money if I need it?
Yes. Nearly all 401k plans allow participants to withdraw their account balances in the case of financial hardship. Your definition of hardship probably differs from the IRS’, so you may wish to visit their website.
9. How does vesting work?
Vesting refers to the percentage of the employer account balances you are permitted to take with you if you leave your employer. You are always 100% vested in your traditional pre-tax 401k and Roth 401k contribution accounts.
If your employer has a vesting schedule for its employer accounts, you will see the vested percentage that is yours increase with your length of service. If you work for the employer long enough, you will become 100% vested in the employer accounts.
Most vesting schedules are five years. That means participants accrue a 20% vested balance after one year, a 40% balance after two years and so on until they become 100% vested after five years.
10. Is my employer required to make contributions?
No. However, that does not mean that most employers don’t. In fact, just the opposite is true. Most employers make matching contributions. The most common matching percentage is 3% — usually expressed as 50% of the first 6% of employee contributions.
You should make sure that you capture the full matching contribution from your employer. This is free money. There is no better investment that you can make.
I hope these answers to the most frequently asked 401k plan questions have helped you better understand your 401k plan.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs, and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly $475 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges, and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.