As you near retirement, you'll want to brush up on all the rules that apply to your 401(k) money. Here are six things you should know.
How Much to Contribute
It is easy to assume that you should contribute to your 401(k) plan and that you should contribute as much as possible, but this is not always true. There are times where it may make sense not to contribute. You have to consider your other savings plans, the availability of a company match, and taxes.
A simple rule such as "contribute 10%" of your pay does not work for everyone. That may not be enough for a high-income earner and it may be way too much for a lower earner.
By the time you reach 55, you should have confidence that the amount you are saving is appropriate for your situation. If you aren't sure how much to contribute, it's time to get a retirement planner to help you figure it out.
How to Invest
Research shows that people spend more time planning their vacation or shopping for a new car than they do planning for retirement. Yikes! And some of you mistakenly assume that if you are trying to make up for lost time, then perhaps you should take on more risk and invest aggressively. That is not a good idea.
What is a good way to invest this portion of your nest egg? If you aren't sure what to do, consider these three foolproof ways to invest 401(k) funds: use target-date funds, balanced funds, or model portfolios.
These options automatically diversify the funds for you and keep you from the folly of only choosing funds that had the highest returns last year. Investing based on past returns is not a prudent approach.
401(k) Vesting and What It Means for You
If you are considering a change of employment or retirement before you decide when to make the change, read up on 401(k) vesting. Vesting refers to how much of the 401(k) money that your employer contributed on your behalf gets to go with you. Sometimes waiting a few months to make a change could mean you will get more.
Maybe, each year, your company makes a profit-sharing contribution, but you must be employed on the last day of the year to be eligible. That would be worth knowing before you pick your retirement date. Take the time to learn what you need to do to be eligible for as much as possible.
What to Know Before You Cash Out Your 401(k)
People make big money mistakes when they cash out their 401(k) plan. You may think it is a good idea to cash out an old plan to pay off debt, but it may be one of the worst things you can do. That's because 401(k) money is creditor-protected. By cashing in, you could void that protection.
There are also age-related 401(k) withdrawal rules to know about. Many plans offer penalty-free withdrawals between age 55 and 59 1/2—only if you retire after reaching 55 and if your money stays in the plan. Taking money out of the plan could void the option to access it penalty-free, resulting in a 10% tax penalty.
Options to avoid this outcome include rolling your 401(k) into another retirement account option, like a traditional IRA that you control. If you're in that situation, it is worth discussing this option with a tax professional before withdrawing funds.
What Happens to Your Outstanding 401(k) Loans?
If you leave an employer and have an outstanding 401(k) plan loan, did you know that the entire loan may be treated as a distribution to you and reported as taxable income? Penalty taxes could also apply. Don't let that happen. You'll want to work toward paying off any outstanding loans before you retire or change employers.
How to Take Money Out of the Plan
It is your money, and you need to know how to use it when the time comes. Different rules apply depending on your age and your employment status.
For example—as mentioned—if you leave your money in the plan, but leave your employer between age 55 and 59 1/2, you may be able to access 401(k) money without paying the 10% early withdrawal penalty tax. If you roll it to an IRA, you would lose this option.
Explore both the pros and cons of taking money out of your 401(k) plan before making a move. In most (but not all) cases, rolling money to an IRA can make sense, as it gives you a wider variety of investment options and gives you more ways to withdraw (some plans don't let you take monthly distributions, for example). Also, with an IRA, it is easier to handle administrative items like address changes, beneficiary changes, and required distributions once you reach age 70 1/2.