Most Americans who work for an employer are familiar with a 401(k) plan. It is a retirement savings plan – sponsored by their employer – which allows them to save and invest a portion of their paycheck into the fund, either on a tax-deferred or tax-free basis. In addition, most companies also provide some kind of matching program that will match a percentage of what the employee contributes into their plan. 401 (k) plans have been, and continue to be, one of the most useful and advantageous components of any employee’s retirement program.
As mentioned above, contributions can be made into the plan on a tax-deferred or tax-free basis. With regard to a tax-deferred approach, the employee contributes a certain amount of money from their paycheck into the plan before taxes have been taken out. Over time that money will continue to grow; however, when that money is eventually withdrawn from the plan (either at age 59.5 or beginning at age 70 when the Required Minimum Distribution takes effect), taxes will have to be paid on that money.
The tax-free approach is different. An employee also makes regular contributions into the plan but only with money that has already been taxed. Since the money was originally taxed before it was contributed to the plan, it will not have to be taxed again when it is eventually withdrawn from the plan. In this way, the withdrawn funds are considered to be tax-free.
No matter which approach an employee might choose, the most important thing an employee can do is to participate in the 401 (k) plan that is available to them through their employer. And choosing not to participate is the first big mistake that some employees make when it comes to formulating their retirement plans.
Make Sure to Participate
Some people mistakenly believe that the money they contribute into a 401 (k) plan belongs to their employer and they fear that if something should happen to their company – bankruptcy or go out of business – they will lose all the money they have put into their plan. Those fears often prevent them from participating at all.
Let me be very clear about this: the money that is contributed into a 401 (k) plan belongs to the employee, not the employer. The plan is set up in a trust account for the employee, so under no circumstances can a company abscond with or confiscate the funds.
The gravest error that an employee can make is to not participate in their employer-sponsored 401 (k) plan. For most people, it is the surest way to provide for a secure and comfortable retirement.
Make Sure to Contribute Enough
The advantage of a 401 (k) plan is that by making small regular contributions, the funds will grow over time and be able to help support your retirement goals. However, in order to take full advantage of the plan and to reap the full benefits of a company’s matching program, an individual has to contribute a sufficient amount to their plan.
Some people believe they are doing well if they contribute 1-3% of their income but that’s not really enough (though it’s better than nothing). A better rule of thumb is to contribute 10-15% of your income, and this is especially true if your company has a matching program in place.
Some companies have matching programs anywhere from 1-10%, which means the employer will match whatever the employee contributes up to a certain percentage. For example, let’s say that my employer has a 5% matching program but I am only contributing 3% of my income. Therefore, I am missing out on the additional 2% that the company would give me for free, if I were contributing at the 5% level.
Make sure you know exactly what your company’s matching program entails and at least contribute enough money into your 401 (k) plan to take full advantage of it. Otherwise, you run the risk of leaving free money on the table.
Make Sure to Conduct a Periodic Review
Too often people will invest in whatever default investment vehicles are offered by their plan and then promptly forget about them. They continue to make their regular contributions but they aren’t actively engaged in their 401(k) investment strategies.
It is a good idea to conduct a periodic review of your 401 (k) plan to make sure that your investments and objectives are still properly aligned. If you’re investing too aggressively, you might consider a more conservative approach, or vice versa.
Some companies offer financial planning or guidance as a benefit to help their employees conduct a professional review of their plan now and then.
Make Sure to Rollover your Plan
Finally, one of the biggest mistakes an individual can make with their 401 (k) is to cash it out when they change jobs or leave their employer. There is a strong temptation to get the plan funds away from the previous employer, so often they will cash out the plan, even though they will have to pay taxes and penalties on the funds that are withdrawn.
It is far better to wait until you have secured another job and then rollover your 401 (k) funds into the plan that is offered by your new employer. Or, if you have decided to become self-employed, then to rollover the funds into an IRA retirement account.
Don’t make the mistake of cashing out your 401 (k) early and losing all the savings and tax benefits you have accrued until that point.
Taking a proactive approach to your finances is to take productive steps toward financial freedom, and a solid 401 (k) plan will help you to achieve that goal.