The 401(k) is one of the most powerful tools in your retirement planning toolbox, but in order to make the most of it, you’ll need to have a good understanding of how it works.
The most important thing you can do right now is to simply start saving. Roughly half of Americans are not contributing anything to their 401(k), according to a survey from Edward Jones, which can lead to long-term problems. It’s much easier to save for retirement when time is still on your side, so the earlier you begin stashing cash for the future, the better off you’ll be.
If you are currently saving for retirement, you’re not quite off the hook yet. There are still a few other smart moves you can make right now to maximize your 401(k).
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1. Contribute at least enough to earn the full employer match
One of the greatest perks of investing in a 401(k) is that your employer may match a portion of your contributions. Employers who offer this benefit will match your contributions up to a certain point — usually around 3% to 6% of your salary. So if you’re earning $50,000 per year and your employer will match your contributions up to 3% of your salary, that’s $1,500 per year. If you’re not taking advantage of this perk, you’re essentially missing out on free money.
If you’re having trouble saving in your 401(k), try setting up automatic contributions. Many employers will allow you to set aside a portion of every paycheck and put that money directly into your 401(k). That can make it a little easier to save because the money never reaches your bank account in the first place, helping you resist the urge to spend it.
Figure out how much your employer will match, then set up your 401(k) plan so that you’re automatically saving enough to earn the full match. If you have cash to spare, you can always save more. But at a minimum, you should at least be taking advantage of all the free money you can.
2. Make sure you know what you’re paying in fees
One of the most commonly misunderstood aspects of the 401(k) is how much you’re paying in fees. Approximately 37% of Americans don’t believe they pay any 401(k) fees at all, according to a survey from TD Ameritrade, and another 22% don’t know how to determine what they’re paying in fees.
The unfortunate reality is that everyone pays 401(k) fees. You won’t receive a bill or even a statement telling you how much of your money is going toward fees, though. Rather, the money is simply deducted from your overall savings, which can make it tough to see just how much you’re paying. The most important figure to look at, then, is the expense ratio — or the percentage of your assets that are going toward fees. You can usually find this number by reading the fine print in your 401(k) statements, or you can talk to your employer’s plan administrator.
The average 401(k) plan charges about 1% in total fees, according to a study from the Center for American Progress. If you’re paying fees higher than that, you might want to look into opening an IRA with lower fees. Even if your fees are only a fraction of a percentage point higher than average, that money adds up. The average worker paying 1% in fees will pay around $138,336 in fees over a lifetime, according to the Center for American Progress. But if that same worker were to pay 1.3% in fees, that number jumps to $166,420. In other words, lowering your fees even the tiniest bit can potentially save you tens of thousands of dollars.
One caveat, though, is that no matter what you’re paying in fees, you should still contribute enough to your 401(k) to earn the full employer match — because free money outweighs any fees. Once you’ve contributed that much, you can look into investing the rest of your cash in a different retirement account with lower fees.
3. Avoid borrowing or withdrawing money if at all possible
If you’re in a tight spot financially, it can be tempting to dip into your 401(k). It is your money, after all, and surely borrowing or withdrawing a few hundred or thousand dollars won’t make a big difference over a lifetime, right?
In reality, though, tapping your 401(k) before you retire can result in some severe long-term consequences. If you withdraw the money before age 59 1/2, you’re instantly subject to a 10% penalty and income taxes on the money you take out. Even if you borrow the money by taking out a 401(k) loan, there are still risks involved. You typically need to pay back the money within five years with interest, and if you leave your job before you’ve repaid the loan, you’ll usually need to pay back the loan in full by the time your next tax return is due. If you can’t pay the full loan amount in that time period, you’ll be in default and the money will be considered a withdrawal — meaning you’ll have to pay taxes and the 10% penalty on your outstanding loan amount if you’re under age 59 1/2.
One of the biggest risks involved in tapping your 401(k), though, is that you’re missing out on valuable time to let your money grow. Your investments rely on the power of compound interest, which is essentially when you earn interest on your interest. The longer your savings sit untouched in your 401(k), the faster they’ll grow. So when you take money out of your 401(k) — even if you pay it back — you’re slowing down the growth process and potentially missing out on thousands of dollars in investment gains.
If you have access to a 401(k) through your employer, it’s wise to take full advantage of it. Making the most of your 401(k) can make it easier to prepare for retirement, ensuring you’re entering your golden years on the right foot.
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Katie Brockman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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