Why You Should Fine-Tune Your 401(k)

Point of Interest

Fine-tuning your 401(k) should be done often, ensuring you’re getting the most out of your account. 

Many employers offer 401(k) retirement accounts as a feature of company benefit plans. While 401(k)s are reliable financial tools, they are not set-it-and-forget products. To maximize your returns and best prepare for retirement, you need to regularly review and fine-tune your 401(k) investment options.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement account. Employees are given the option to contribute to their accounts regularly up to the maximum limits imposed by the IRS. Often, employers will offer an incentive to match your retirement account contribution up to a certain dollar amount or percentage. For many, this can spell thousands of dollars in added benefits every single year.

It’s important to know that 401(k) retirement accounts are different from pension plans. Pension plans are investment accounts that the company provides without a need for the worker to make contributions. 401(k) accounts shift the onus of responsibility onto the worker to drive the growth of the account.

401(k) investment options

Your 401(k) is a type of account that is made up of several different types of individual investments. The title is an overarching term for the type of account and not what you are invested in. What you are invested in are different investment products that collectively are referred to as your 401(k) retirement account.

These investment options include things like stocks, bonds, mutual funds, CDs and exchange-traded funds. Depending on the level of risk you’d like to accept, you can choose how you’d like your funds allocated. In other words, different employees at the same company might have two very different 401(k) accounts that produce different levels of return.  

When choosing what types of investment options you want to utilize, you need to weigh several different factors. 

“Several considerations should be taken into account when fine-tuning a 401(k), including your marginal income tax bracket, the types of accounts you have access to, internal investment fund expenses, and allocating investment selections to your long-term retirement goals  — more aggressive when young, more conservative when older,”  says Chad Rixse, director of financial planning and wealth with Forefront Wealth Partners.

As Rixse mentions, there are different types of 401(k)s you may have access to — traditional and Roth. Traditional 401(k)s are tax-deferred up to the maximum amount you are allowed to contribute for the year. In other words, you don’t pay any taxes on the income you use to fund your 401(k). When you withdraw your funds at retirement, you will pay taxes. But a lot of people will be at a lower tax bracket at that time, which may provide tax benefits.

Roth 401(k)s are not tax-deferred and require you to pay your normal income taxes on the money that you invest in your account. But when you withdraw the money at retirement, you will pay no taxes. These types of accounts are great for workers early in their careers when they might not be making as much money as they expect to be when they retire.

One of the most important factors to consider when determining your 401(k) investment options is if your employer is offering funds matching. While unique situations may exist, you should be contributing the maximum that is matched every year, if at all possible.

For example, let’s say your employer is willing to match up to 3% of your salary. If you make $50,000, 3% is $1,500. This means that if you put $1,500 into your 401(k), your employer will also put $1,500 into your account, giving you an account balance of $3,000. When you don’t contribute enough to earn the maximum in matching funds, you are leaving free money on the table.

You should also be regularly reviewing your account performance and asset allocation. As you move closer toward retirement, the risk level of your accounts should be decreasing. Those early in their careers and far from retirement can afford to take more risks in search of better returns. However, as you near retirement, the possibility of losing a significant chunk of your retirement savings becomes more detrimental.

Withdrawing from your 401(k)

To withdraw money from your 401(k) without penalty, there are several criteria you must meet. If you are between the ages of 55 and 59 ½, most plan options will allow you to start taking withdrawals without penalty as long as employment did not end earlier than the year you turned 55.

If you are 59 ½ or older, withdrawal depends on whether you are still working or not. If you are fully retired, you can access your funds with no penalty. If you are still working, you can access funds from any 401(k) accounts not tied to your current employment. Most likely (with exceptions), you will face an early withdrawal penalty if you take funds from the 401(k) attached to your current job.

You are not required to take anything out of your 401(k) until you turn 72 years old. At this time, you will need to start taking required minimum distributions from your account. Certain plans may offer exceptions, so check with your plan manager if you have specific questions.

What happens if you want to access your 401(k) funds early? You do have options. First, you may be able to qualify for a special hardship withdrawal for things like medical expenses, funeral expenses, home purchase expenses, casualty losses to a principal residence and some tuition costs. Withdrawals under these conditions are not subject to an early withdrawal penalty.

Your second option is to take out a 401(k) loan. This option provides a short-term cash infusion but does need to be repaid to avoid penalties. Your last option to get money from your 401(k) is to bite the bullet and take the early withdrawal penalty. The penalty is 10% on all funds withdrawn.

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