The days of pensions being handed out at corporations is a dying trend. In its place came the 401k or 403b for you government employees. Congress passed the Revenue Act of 1978 which included a provision saying that employees could save their money with pretax dollars (aka deferred compensation). It was a huge step in the right direction for millions of Americans. Today we will cover some of the best known benefits of the 401k to maximize your returns.
1: Not receiving your match is lost money. If your company offers any sort of match, make sure you at the very minimum contribute what is needed to get the match. Consider it free money for your hard work.
2: Tax Sheltering. This is probably my favorite part of the 401k/403b. It effectively lowers your tax rate by a substantial amount. Meanwhile all the money will grow tax free for the next 30+ years. Most likely your tax bracket will be lower during retirement than your prime earning years. Maximizing the 401k also drops any capital gains tax as long as you do not withdraw money.
3: You can start taking distributions at 59 1/2 without any penalties. You will incur income taxes and state taxes depending on where you live. Anything prior to that is subject to a %10 penalty and is also taxed as income. Some plans offer a loan which you would pay back with interest for a determined amount of time. In some extreme cases you can take a hardship loan which could be used to pay for hospital expenses, back mortgage payments or funeral services. If at all possible you should never withdraw money from your 401k. You will miss out on years of compounding growth.
4: Diversify. Most 401k’s are managed by some financial planner that your employer uses. While these people are professionals remember that they also get paid on commissions which depends on where your money is allocated. Check your 401k often to make sure the performance is up to par with what is happening in the market.
5: Fees. Unfortunately this is something you cannot escape. The only thing you could possibly do is pick funds with lower expense ratios. Vanguard has the largest selection of mutual funds with extremely low expense ratios. Over many years this can save you $10,000-$100,000+. Definitely not chump change by any amount. Aim for funds with an expense ratio of less than %1.
6: Auto Escalations. Some 401k plans offer an auto escalation setup. If at all possible sign up for this. Set it up for %1- %2 increases every year until it maxes out. This should keep pace with your yearly raises due to inflation.
These are just some of the great things about 401k’s. Before pumping all of your money into these accounts do make sure your financial house is all in order first. I would advise not to increase contributions if you are saddled with high interest debt of any sort.
Feel free to post any questions below!