Motley Fool
0
All posts from Motley Fool
Motley Fool in Motley Fool,

5 401(k) Facts You Didn't Know

"The thing to do is to make so much money that you don't have to work after the age of twenty-seven. In case this is impracticable, stop work at the earliest possible moment, even if it is at a quarter past eleven on the morning of the day when you find you do have enough money."
-- Robert Benchley 

Many of us would like to retire as soon as possible -- but we know we can't until we have enough money, whatever that sum is. If you're working to amass enough money to retire, don't underestimate the power of a 401(k) account.

Image source: Getty Images.

Here are five 401(k) facts you would do well to know.

401(k)s feature hefty contribution limits

If you're familiar with traditional and Roth IRAs, you may know that their current contribution limit is $5,500, plus a $1,000 catch-up contribution for those 50 or older. That's good, and it can help you accumulate a lot toward retirement, but a 401(k) account can be about three or four times as powerful, because of much higher contribution limits. For 2017, you can contribute up to $18,000 to your 401(k), plus an additional $6,000 if you're 50 or older -- for a possible total of $24,000!

Image source: Getty Images.

401(k)s often offer free money

There are very few investments out there that offer guaranteed, substantial returns, but 401(k) accounts typically do. That's because 401(k)s often feature matching contributions from employers. A common employer match is 50% of the contributions you make up to 6% of your salary. So if you earn $70,000 and contribute 6%, or $4,200, your employer will add another $2,100. That's $2,100 of free money and a guaranteed 50% return on your investment that you'd be hard-pressed to find anywhere else.

Image source: Getty Images.

You can save a lot of money with a 401(k)

Remember the sizable contribution limits for 401(k)s? Well, they can help you accumulate a lot of money for retirement -- and most of us will need it.

The table below shows how much you can accumulate by making big annual contributions to a 401(k) and/or other retirement savings accounts over as many years as possible.

Growing at 8% for...

$5,000 Invested Annually

$10,000 Invested Annually

$15,000 Invested Annually

10 years

$78,227

$156,455

$234,682

15 years

$146,621

$293,243

$439,864

20 years

$247,115

$494,229

$741,344

25 years

$394,772

$789,544

$1.2 million

30 years

$611,729

$1.2 million

$1.8 million

Calculations by author.

If you're somewhat close to retirement and are worried that you won't be able to accumulate enough money, take comfort in the fact that there are some ways to generate more retirement income.

Image source: Getty Images. 

Consider a Roth 401(k)

Here's something you may not know: Just as there are two main kinds of IRAs -- traditional and Roth -- there are also, at many companies, traditional and Roth 401(k)s. With a traditional IRA and 401(k), you contribute pre-tax money that reduces your taxable income and, therefore, your tax bill for the year. (Have income of $70,000 and a contribution of $5,000? Boom -- your taxable income drops to $65,000.) The contribution is taxed as ordinary income to you later, when you withdraw it in retirement.

With the Roth IRA and 401(k), you contribute post-tax money that doesn't deliver any upfront tax break. (Income of $70,000 and $5,000 contributed to a Roth 401(k)? Your income is still $70,000.) But you eventually get a big tax break when you withdraw from the account in retirement – because if you follow the rules, you get to take all the money out of the account tax-free. A Roth 401(k) can be especially powerful if you are many years away from retirement, as your dollars have longer to grow.

401(k)s aren't perfect

Finally, despite all the truly wonderful things about 401(k) accounts, they're not perfect. That doesn't mean you shouldn't use them -- just that you should be aware of their drawbacks. Here are the key ones:

They offer limited menus of investment choices: Many 401(k) plans let you choose only from among a handful of mutual funds. By contrast, most IRA accounts let you invest in just about any stock and offer access to hundreds or even thousands of mutual funds.

They charge fees: A 401(k)'s fees can sometimes be quite significant, and even when they seem small, they can do meaningful damage to your ultimate results. (Indeed, some plans charge big fees even for index funds that you can invest in elsewhere for a pittance.) A Wall Street Journal article last year noted, "According to Vanguard Group, investors in a plan that charged 0.25% a year could in theory amass 20% more money over a four-decade career than they could in one that charged 1.25%, all else being equal." A Department of Labor report offered a starker example:

Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.

Fortunately, fees have been falling in recent years, in part due to lawsuits brought about against some employers. In the meantime, you can look up ratings for many companies' 401(k) plans at www.brightscope.com, where it rates them on fees, among other things.

Your money will be locked up for a while: You generally can't withdraw money from your 401(k) until age 59 1/2 without getting slapped with a 10% early withdrawal penalty. There's an exception, though: If you leave your job in the year that you turn 55 or later, the 10% penalty won't apply. Retiring early due to a qualifying disability can also free you from the penalty, as can a few other circumstances, such as financial hardship.

There are required minimum distributions: If you're in no hurry to withdraw money, know that you can't delay doing so forever. A 401(k) account, whether traditional or Roth, features "required minimum distributions" (RMDs). Per the IRS, RMDs are generally required to begin on "April 1 following the later of the calendar year in which you reach age 70 1/2 or retire." (Note that traditional IRAs also feature RMDs, and you can't delay them by delaying retiring.) Withdrawals from a traditional 401(k) will be counted as taxable income to you, while Roth 401(k) withdrawals should be tax-free, as contributions to a Roth 401(k) are made with taxed money.

Some 401(k)s can be under-diversified: Think twice before loading up your 401(k) with stock in your employer. Yes, you know that company best, but remember that it's already providing most or all of your income now. To have it provide most of your future income, too, is putting a lot of eggs in that one basket. Even great companies can fall on prolonged hard times -- or can defy expectations and fail. Try not to keep too much of your net worth in company stock -- perhaps not more than 10%, at most.

401(k)s allow some ill-advised moves: For example, you can cash out your 401(k) when you leave your job. Don't do that, though. Sure, you may have only worked at a given company for three years and may not have much in your account, but if you remove even $20,000 that could have kept growing for you for another 25 years, you could lose out on about $137,000 in retirement money (assuming an 8% average annual growth rate). Similarly, don't borrow from a 401(k) plan, either, unless it's an emergency and you really have no better option. That's another way of stealing from your financial future.

Overall, a 401(k) account can be a tremendous help in saving for your retirement. Make good use of it if you're offered one at your workplace -- and don't cash it out when you change jobs. Instead, look at rolling it over to keep your money working as hard as it can for you.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.