Why Maxing Out Your 401k Could Mean Missing Out On Thousands
For many of us, our 401 or similar employer-sponsored retirement plan is our primary vehicle for retirement savings. A is a defined contribution plan meaning that our retirement benefit is determined primarily by the amount that we save and how we invest those savings. However, there is a maximum 401k contribution limit that we will cover.
These types of plans have primarily replaced pension plans of our parents and grandparents generation, which were funded mainly by employers.
Ideally, you got started saving for your retirement in your companys 401 plan right out of the box when you started working. If not, hopefully, by now you have gotten going and this is a regular deduction from each paycheck.
Its not easy to do when youre in your twenties. There are plenty of other things on your mind than saving money out of your paycheck. It’s a tough pill to swallow in our instant gratification society, and an even more challenging concept to teach.
However, if youre reading this today, then youre probably well on your way to contributing to your 401 and, most likely, on an annual basis. To that, I say congratulationsyou have made a great achievement.
For 2021, the new maximum contribution has increased to $19,500. If you are 50 or older, then you can contribute an additional $6,500 for a total of $26,000. Thats a lot of money on an annual basis from what the 401k maximum contribution used to be.
Do You Max Out Your 401k Mid
I have maxed out my 401K every mid-year since I was in my mid-20s and thought I was doing the right thing. What could be wrong with investing in the stock market sooner and getting a bump in pay when you max out mid-year? So last year, I decided to be even more aggressive and I maxed out my 401K by March!
I didnt realize how stupid this was until I learned a little bit more about employer matching and how it works.
Note: You can to customize all the charts you see in this article for your specific needs.
Understanding Early Withdrawal From A 401
The method and process of withdrawing money from your 401 will depend on your employer and the type of withdrawal you choose. Withdrawing money early from your 401 can carry serious financial penalties, so the decision should not be made lightly. It’s really a last resort.
Not every employer allows early 401 withdrawals, so the first thing you need to do is check with your human resources department to see if the option is available. If it is, then you should check the fine print of your plan to determine the type of withdrawals that are allowed or available.
As of 2021, if you are under the age of 59½, a withdrawal from a 401 is subject to a 10% early withdrawal penalty. You will also be required to pay normal income taxes on the withdrawn funds. For a $10,000 withdrawal, once all taxes and penalties are paid, you will only receive approximately $6,300. There are some non-penalty options to consider, however.
Before deciding upon taking an early withdrawal from your 401, find out if your plan allows you to take a loan against it, as this allows you to eventually replace the funds. You may also want to consider alternative options for securing financing that could hurt you less in the long run, such as a small personal loan.
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What Happens When You Borrow
The rules about 401 plans can seem confusing to workers. While employers aren’t required to offer the plans at all, if they do, they are required to do certain things but also have discretion over how they run the plan in other ways. One choice they have is whether to offer 401 loans at all. If they do, they also have some control over which rules to apply to repayment.
According to Michelle Smalenberger, CFP, Your employer may refuse to let you contribute while repaying a loan. Smalenberger is the cofounder of Financial Design Studio, a fee-only financial planning and wealth management firm. When an employer chooses what plan they will offer or make available to their employees, they have to choose which provisions they will allow.
If you cant contribute while repaying, remember that your employer is giving you a benefit by allowing the loan from the plan in the first place, Smalenberger adds.
And if you cant make contributions while youre repaying your loan, be aware that a higher amount of your paycheck will go to income taxes until you resume contributions.
If your employer does allow plan loans, the most you can borrow is the lesser of $50,000 or half the present value of the vested balance of your account, minus any existing plan loans. You must repay the loan within five years. And taking a loan puts you at risk of facing the obligation to repay it within a narrow time limit, typically 60 days or less, if you are laid off or quit.
What Is A Defined Contribution Plan
A defined contribution plan is any retirement plan to which an employee or employer regularly contributes some amount. Often, the employee chooses to send a fixed percentage of monthly income to the account, and these contributions are automatically withdrawn, directly from her paycheck – no effort required. The money that doesn’t go to the employee’s take-home pay gradually accumulates, the balance earns interest from investments, and by the time retirement rolls around, its grown into a substantial nest egg for the retiree. Thats the idea.
In a defined contribution plan , there are no guarantees about the income youll receive in retirement. That doesnt mean such plans cant be just as effective, however, and employers often sweeten the deal by making contributions of their own, straight into your account.
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Why You Can Trust Bankrate
Founded in 1976, Bankrate has a long track record of helping people make smart financial choices. Weve maintained this reputation for over four decades by demystifying the financial decision-making process and giving people confidence in which actions to take next.
Bankrate follows a strict editorial policy, so you can trust that were putting your interests first. All of our content is authored by highly qualified professionals and edited by subject matter experts, who ensure everything we publish is objective, accurate and trustworthy.
Our reporters and editors focus on the points consumers care about most how to save for retirement, understanding the types of accounts, how to choose investments and more so you can feel confident when planning for your future.
When You Have Too Much Debt
While its always possible to both pay down debt and make 401 contributions, large debt loads charging high interest rates may require more budgetary attention. Very high APRs from your credit card issuers or a debt-to-income ratio thats too high may mean you should prioritize paying off debt ahead of saving for retirement.
The key thing to consider is how much youre paying in interest on your debt compared to the returns youre getting on your investments. If youre paying an APR of 15% to 20% to a credit card company but youre only seeing an annual return of 5% to 8% on your 401 investments, you may be losing money. That said, pausing contributions to accelerate your debt payoff means youll need to play catch-up on your retirement savings later.
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Protecting Your 401 From A Stock Market Crash
Any time you put your money in the stock market or other investments, you always run the risk of losses. While you can make largely educated decisions, things dont always go to plan. Also, because youre talking about something as important as your retirement, emotional decision-making can come into play.
Despite the above, there are many strategies, simple and complex, you can use to mitigate risk. For instance, spreading your assets across multiple types of investments and areas of the market can allow you to avoid the volatility that comes with stock-picking and concentrated investment positions.
Everyone has short-term expenses that periodically arise. For example, you might need to repair your car, replace a broken household appliance or pay for a medical procedure. Long-term expenses are even more prevalent, including student loans and mortgages. However, the best thing you can do is treat your retirement savings just as importantly as all of your other needs. This will ensure your pool of retirement funds will continue to grow over time.
Below are some of the most influential strategies you can use to minimize losses in your portfolio, even if a stock market crash comes around. Just remember that you can never fully avoid risk, though.
How To Protect Your 401k From A Stock Market Crash
Are you riding your retirement on the success of the stock market? If so, its understandable that youre worried about what a crash could mean for your 401k.
If thats you and youre wondering how to protect your 401kfrom a stock market crash, Ive got good news for you:
You dont have to worry.
The stock market is volatile, but you can minimize that risk with the right investing strategy.
If you invest your money the right way, you can not only protect your retirement but also experience even greater returns so your retirement can be even sweeter. Ill show you how to take advantage of stock market volatility, which includes a stock market crash, so you can profit from the fluctuations instead of watching your portfolio take a plunge.
Are you with me?
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Reason To Forego 401 Contributions #: Fees Are Excessive
Investing in a 401 may not offer any real advantages if the amount of fees youre paying counteracts any returns you might see. The Department of Labor instituted tougher regulations in 2012 to make fee disclosures more transparent but many participants still remain in the dark about how much theyre actually paying. According to a study from researchers at Yale, 16% of retirement plans analyzed had fees that completely negated the tax benefit for young savers.
Parking your money in an IRA instead means you wont be able to save as much since the annual contribution limit is lower but you may be able to escape some of the hefty fees. If youre not planning to stay with your current employer for a significant period of time, not participating in their plan saves you the hassle of trying to roll it over once you move on.
Consider A Simple Index Fund
Strangely, a simple index fund that tracks an underlying index like the Standards & Poors S& P 500 is one of the safest investments around.
For instance, the annual return of the S& P 500, the 500 most valuable publicly traded companies in America, between 1926 and 2018 was 10%. Notably, that period includes four stock market crashes in 1929, 1987, 2000, and 2008. Yet, the overall market growth continued despite World War II, the Great Depression, the Cold War, September 11, many political crises, and other cataclysmic events.
Indexing can protect your money because it diversifies it. For instance, the S& P 500 contains a wide variety of companies in different businesses.
Additionally, indexing protects your money from emotions because it is automatic. Hence, nobodys prejudices are influencing how they pick the stocks. Instead, an algorithm picks the stocks using simple criteria, such as the companies value.
- Tip: Stock Rover provides detailed reporting and ratings for all ETFs and Mutual Funds in the USA & Canada
Thus, putting 10% to 25% of your 401K in an exchange-traded fund like the State Street S& P SDR 500 can protect your money. However, indexed funds are vulnerable to short-term losses.
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If You Have Already Been Laid Off
If you’ve lost your job, you’re not alone. About 6.6 million Americans filed new unemployment claims last week, the Labor Department reported Thursday. And that number is expected to grow.
But losing your job does mean you need to tighten your belt. In fact, Ginty recommends dramatically cutting your budget back to just the bare essentials because you’ll probably be dipping into any emergency savings you have. You’ll also want to file for unemployment and keep an eye out for the government stimulus check of up to $1,200 that most Americans should receive by mid-April.
This is not the time to focus on rebalancing your retirement accounts, Gorelick says. Generally, if you have more than $5,000 in your 401, you can leave your savings in your existing account.
If you have less, you may have to make some decisions now. Your employer can cash out your account if you have under $5,000 and send you a check. But typically employers will roll over your 401 balance into an individual retirement account if you have at least $1,000 unless you specify otherwise. Pay close attention to any paperwork or mail you may be receiving from your employer or your 401 plan provider.
If your 401 provider won’t do a direct rollover or employer cuts you a check for your 401 balance, you have 60 days from the date you receive it to transfer it to another 401 plan or IRA without being taxed.
Contributions Are Often Tax
In other words, your taxable income is reduced, so you end up paying less in tax. If you instead choose not to put those dollars aside, the federal and state governments will take a bigger chunk of your pay in income taxes. Not only will you end up with less money in your retirement account, but you’ll also have less cash in your hand today. It’s sort of like killing the chicken for meat now when you could live off the eggs for a much longer time.
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It’s Sometimes Possible To Get A Tax Deduction But That May Not Be Worth It
The government allows you to claim a tax deduction if your 401 or other retirement plan has lost value, but there are rules you must follow. First, you must have basis. In this case, basis refers to nondeductible contributions you’ve made. Deductible contributions — those that reduce your taxable income for the year — do not count. You haven’t paid any taxes on that money so far, so the government is not going to give you a tax deduction on the amount you lost.
You also must close all retirement accounts of the same type in order to calculate the loss. So if you’re trying to claim a loss on your 401, you must close all of your 401s. Then you total your nondeductible contributions and the current value of the accounts, and you can write off the difference if the current value of the accounts is lower.
But this is inconvenient for two reasons. First, if you withdraw money from your 401 before age 59 1/2, you pay a 10% early-withdrawal penalty. This may negate some of the benefit you get from writing off the loss. Second, if you take the money out of your 401, you’re giving up the tax advantages it offers and your money will no longer grow as quickly unless you invest it in something else.
For these reasons, it’s not wise to claim a tax deduction on a 401 loss unless you’re older than 59 1/2 and plan to use the money to cover your retirement expenses in the near future anyway. Otherwise, try one of the suggestions above.
How To Stop 401k Contributions And Put Money In Savings
People in a difficult financial situation often consider stopping contributions to their 401 retirement plans either permanently or temporarily. Many financial advisers warn not to stop contributions to your 401 unless your company has stopped matching your contributions or you are close to retirement age. However some employees are temporarily stopping their 401 contributions to put money into savings instead. The process is fairly simple and can be done through the human resources department at your place of employment.
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Other Benefits Of A 401
Even for employers who do not offer any matching program, every employer with a 401 plan is responsible for administering the plan. That may seem like its no big deal, but it actually saves quite a bit of trouble for the employees. As an employee in a 401 plan, you dont have to worry about the complicated rules and regulations that need to be followed, or about making arrangements with the funds in which you invest your moneyyour employer takes care of all of that for you. Thats quite a bit of saved paperwork.
At the same time, employees who participate in a 401 maintain control over their money. While employers provide a list of possible investment choices, most commonly different sorts of mutual funds, employees have quite a bit of freedom to decide their own strategy. Whether you are willing to take on a little more risk with your investments, or if you would rather play it safe, theres probably an option for you.
Should I Close My 401k And Withdraw My Funds
When American consumers take a whack in the wallet like they did with the coronavirus pandemic in the spring of 2020 asking for relief from their 401k account is a legitimate question.
The legitimate answer is: NO, DONT DO IT!
Not even if the federal government dangles some tantalizing incentives like removing penalties for early withdrawals, which they did during the COVID-19 pandemic in 2020.
The reason temporarily was bold-faced was the option ended December 31, 2020. The 10% penalty for withdrawals before the age 59 ½ is back in play.
Before the CARES Act was passed, taking an early withdrawal was available only to people 59 ½ or older. It was not an advisable choice before COVID-19 and its not an advisable choice after.
If you can avoid it.
A 401k account is a vital part of your financial future and should never be toyed with. However, if something drastic like COVID-19 brings the U.S. economy to its knees and your job/income sinks with it your 401k account might seem like the only ticket to get back on your feet.
Its not for two very good reasons:
- The value of stocks and mutual funds typically plummet during a crisis. Your investment might already have lost a significant amount of its value during a market downturn, meaning you already have significantly less money to borrow from.
- Less money in the account means you definitely will lose out on the gains from compounding interest that make long-term investing so attractive.
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