Day in and day out you’re bombarded with endless variations of that same question. Invariably, this question leads to the topic of a 401(k). It’s promised as the panacea for your dim, penniless future. But the signal to noise ratio can be deafening, and, often times, confusing. So let’s attack this topic with some firm facts, some simple examples and critical insight.
We are going to assume you understand the general idea of a 401(k). Pensions are a dying breed, and many have grown up knowing only 401(k)s. But not everyone is utilizing their 401(k). Or, if they are, they might not be getting the most out of it.
Match It Up
Most 401(k)s offer an employer match. That is to say, for every dollar you contribute, your employer will match that dollar with a contribution of their own. These contributions come in many different forms. The most common match is a dollar-for-dollar match up to the first 6% contributed. That is a fantastic fact, and here is why.
Any time you receive a match in your 401(k), you’re receiving a tax-free bonus. So, if you have the average plan of a 6% match, you effectively receive a 6% raise if you contribute 6% of your salary into your 401(k). But wait, there’s more: if you’re contributing to a Traditional 401(k) rather than a Roth 401(k), your contributions are also pre-tax. Remember the pre-tax statement; we will explain the power of that momentarily.
Let’s keep this concept simple: no matter the percentage you receive for your match, no matter how much the match contribution is, you will effectively receive a raise if your contribution is set to meet the maximum match limit. If your firm will match only the first 1% of your contributions, that would still be a 1% raise. If they don’t match dollar-for-dollar, instead they only match $0.50 to your dollar that is still a $0.50 raise for every dollar you contribute.
That’s a powerful benefit at your disposal. And as such, you should always strive to contribute to your 401(k) up to the amount of which your employer will match, if you can afford to and if you plan to meet the vesting requirements.
Sometimes we encounter those pesky little vesting requirements. We are inundated with the idea that in today’s world, employees are constantly moving to new firms. A 30-year career at the same company simply does not happen anymore, or at least it is very rare to hear about these days. And the damage that can do to your retirement savings is a little discussed issue.
So, what are your company’s vesting requirements? And what is your expectation of your future with them? The answers don’t always have to match up.
If your company does cliff vesting — with the first two years you have nothing vested but the third year you become 100% vested — you would be remiss if you ignored your 401(k). Three years is a short amount of time. Even if you do manage to leave before three years is up, you’re effectively out nothing. You made contributions to your 401(k) and those will stay in your possession. You lose the employer match, but it didn’t cost you out-of-pocket.
If instead your company vests on a graded cycle, unless you plan to quit with the velocity of the Roadrunner, you’ll see a bonus with every contribution, and the permanence of that bonus will grow until you are fully vested.
Roth-in’ In the Free World
Some of you are lucky in that your employer offers both a Traditional 401(k) and a Roth 401(k). So, this is where things can get complicated. Which 401(k) should you invest in? The answer isn’t simple, and it must be emphasized right now that this decision is the crux of your 401(k) investment plan, which means you should contact your accountant or financial advisor to make the wisest decision. But let’s illuminate the options and strategies available.
The Roth option allows you to invest after-taxes, so the investment comes out tax-free on or after that glorious day you turn 59 ½. Now we can see the ponderous look on your face, and we know exactly what you’re thinking, “Why would I want to pay taxes on my 401(k) now? Won’t my income be less when I retire?”
Perhaps. This is why you need to discuss the decision with a professional. Are you young, and earning very little money and thus you’re near the bottom of the tax bracket? That right there could signify that putting all your chips into a Roth would be a wise decision. Are you making good money, but have a lot of tax deductions at your disposal already? Then you too might want to consider a Roth. Keep in mind that the longer your time to retirement, the more you might benefit from Roth contributions: those taxed dollars will (theoretically, at least) grow more over a long timeframe, so you will pull out more earnings tax-free in 40 years than you would after only 20 years.
Understand that your decision of a Roth versus a Traditional 401(k) is not permanent, nor should it be. Your income will change over time, your tax deductions will change over time, and your retirement plans will change over time. That strapping young fellow earning a salary of just $40,000 out of school who dutifully stowed away some of his paycheck into his Roth 401(k) will one day become a manager earning a cool six-figures (unlike Roth IRAs, there are no income limits). Lo and behold, that young fellow now has to reconsider how beneficial a Roth 401(k) is to his yearly tax liability. Chances are good he will lighten that tax burden by switching himself to a Traditional 401(k).
Perhaps that strapping young fellow with a cool six-figure income has bought a house, married, and started a family. With a mortgage, a non-working spouse and dependents, he might be facing another tax liability swing. Perhaps he’s so flush with tax deductions that that Traditional 401(k) is no longer the best answer, and he can invest a bit more in his future by paying tax at a relatively low rate now in order to reap tax-free retirement distributions far in the future.
You begin to see our point, we hope. The events in your life will constantly change; your retirement plans might adjust. The 401(k) decision you made some years ago may no longer be your best option.
We would be remiss if we failed to mention that some plans permit you to convert your 401(k) from a Traditional to a Roth. Market downturns are always tempting times to convert your traditional 401(k) or IRA balances to Roth. But act with caution: these scenarios generally involve current tax payments, and can be complicated to figure out on your own. Multiple factors must be considered, and to get the most out of a conversion, pick up the phone and call your tax professional or financial advisor.
Roll With Me Now
Another consideration is the rollover. Having multiple 401(k) accounts can be cumbersome and confusing. It is harder to properly manage investments when you have accounts at a variety of institutions, even easy to forget that some of them exist.
Even so, you might not always want to rollover your accounts. Depending on the structure and size of your rollover-eligible 401(k)s, you might be better off leaving them in the original plan. Maybe your old plan allows for loans, while your new account doesn’t. While loans are not something to encourage on your 401(k), it can be comforting to have that ability depending on your financial situation or your financial plans.
The size or investment options of your old plans might also prove to be beneficial to you. Large plans can spread out the expenses to reduce the amount of annual fees charged to your account. Depending on just how large the plan is, and the size of your options, you might find yourself wanting to stay with your old plan.
And, your specific situation can make your former employers’ 401(k) more flexible than a rollover IRA. For instance, if you were laid off near retirement age, you might qualify for early distribution without penalty – a benefit you could not obtain from a rollover IRA.
Lastly, how you proceed with the rollover should be considered. Direct rollovers, where funds are transferred from the 401(k) plan directly to your IRA account are strongly recommended. If you want to proceed with an indirect rollover, you definitely want to discuss it with a professional first, to minimize the risk of the rollover being treated as a taxable event.
A Final Word
The options available to you will vary, it will all depend upon the plan your employer provides you with, but know that a 401(k) is there for your future enjoyment. It doesn’t have to be cumbersome; it doesn’t have to be annoying; it can be simple and beneficial. Sit down with your accountant; sit down with your financial advisor. Talk to them. Explain your needs and your wants. Voice all your fears and concerns. Your 401(k) is for you; make it work for you, make it be that plush cushion at the end of your hard-worked journey.
If you have any questions about what’s discussed above, please feel free to contact us at any time. We’re more than happy to help!
Author: Chris Sittner, CPA
This blog post is a summary and is not intended as tax or legal advice. You should consult with your tax advisor to obtain specific advice with respect to your fact pattern.