401(k)s - Your Questions Answered

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The pros and cons of a 401(k) make for an evergreen discussion. These accounts work for some, less so for others, and always require a decent amount of consideration before buying in. As much as we like to have a black and white view of how our finances should be curated, 401(k)s sit right in the gray area.

In the wake of so many jobs being lost and the economy being so shaken, the 401(k) conversation becomes even more prescient. What do you do with your retirement account if you just lost your job? What happens if your company goes out of business before your match is fully vested? How do you make the most of your savings when you’re forced to switch jobs?

These questions rustled feathers before the pandemic, and now the answers might be even more confusing. Fortunately, while there’s no simple solution, there are basic rules and principles that can make the whole 401(k) conundrum a little easier. Your needs and circumstances should determine the rules, not the mumbo jumbo you hear from a broker you’ve never met whose goal is to toe the company line.

This is your money. Its growth will dictate the freedom of your retirement. Now is the time to figure out exactly how it all works so someone else’s interests don’t get put ahead of your own.

When To Have a 401(k)

Except for some unions and a few select industries, the pension has mostly gone the way of the dodo. Workers in previous generations could rely on pension plans and the expectation that they’d stay with one company for the majority, if not all, of their careers. Times and retirement accounts have changed a lot in the last few decades, and 401(k)s have taken over as the most common option offered by employers.

The 401(k) is entirely funded by you, though your employer may offer a matching program. This sweetens the deal for long-term employees, and it offers a nice tax incentive for your boss. Taken at face value, the employer match is the best thing about a 401(k) plan. To make good on this generosity, two things have to be true.

● Your employer has to offer it

● You have to become fully vested

There’s no mandate saying companies need to match contributions, and CEOs also get to decide how much they’re willing to contribute. Assuming the match is offered, you decide what percentage of your pre-tax earnings you want to siphon off to your 401(k), and your benevolent boss will throw in an equal sum up to the percentage of his or her choosing. The average is around 3.5%, but can go as high as 6 or 7% from certain companies. The higher the match, the more inclined I’d be to enroll in the 401(k) program.

It’s important that you at least contribute up to the amount your employer will match so you squeeze every available penny into your retirement. After that, you can either contribute more to your 401(k) or put whatever else you can afford into an IRA or a standard brokerage account. The best feature of a 401(k) is the matching; once you max out whatever your employer offers as a contribution, you could do better by putting your money elsewhere.

Let’s agree that the employee match is the most important part of a 401(k). With that established, you have to look at the vesting situation and do some serious thinking. The majority of companies that offer a match will only pay 100% of their contribution if you stay in your position for a specified number of years. Accounts usually become fully vested after five or six years, and the payout percentage goes down for each year short of that vesting mark. If it’s five years for 100%, you’d get 80% if you stayed on for four years and 60% for three, etc.

I don’t think executives are necessarily being shady with this approach, but I don’t love what it says about the employer/employee relationship. Money going into retirement benefits sometimes comes at the expense of a higher salary, and then to have that money scaled back if you find a new job doesn’t seem entirely fair. Despite my personal opinion, this is the game with a 401(k), and it’s why you need to feel confident about your status with your company when you open the account.

I don’t just mean confident that you’ll keep your job - you need to feel confident you’ll enjoy staying in that position. It’s such a bummer to talk with someone who dreads getting up in the morning because they dislike their work so much, and yet they feel like they have to stick it out at least two or three more years for the sake of their retirement account. I talk all the time about how wealth is freedom, and chaining yourself to a dead-end job just for the 401(k) doesn’t feel all that freeing.

Years ago, a buddy of mine opted not to start a 401(k) with a company match. He was still trying to get out of debt, didn’t know how long he’d be with the employer, and really just didn’t really understand the whole deal. Now, he’s still at the same job and has finally opted into the program. He wasted a good five years of employer matching because he got paralyzed by indecision.

Here’s the thing: even if he had left that company after a single year worth of 401(k) contributions and no vesting at all, he still would have left with a few hundred dollars in a retirement account. That money stays with you and can easily roll over to a better account whenever you want. No vesting is a dragger, but no savings at all is much worse.

The moral of the story is that you need to put money somewhere for the future. Many of you might really benefit from the employer match, staying long enough to get vested and then leaving work with a 401(k) that’s bursting at the seams. That might not be how it always works out, but if the choice is to twiddle your thumbs or start putting money into whatever plan your employer offers, you have to go with option two.

When To Go With an IRA

Infallible Rule: it’s better to have some savings than to have none. Sometimes I feel like I need to add that disclaimer before I start listing the reasons I’m opposed to a certain investing strategy. I shy away from mutual funds, but if you told me the choice was between buying a package of lousy funds and spending $50,000 on chips and salsa for a Cinco de Mayo party, I’d probably encourage you to become a proud mutual fund owner.

The reason not to go with a 401(k) program is that you have a better place to put your money. When it comes to growth and returns, you don’t have to look too far for an option with more promise than your standard 401(k). Whatever firm manages your account usually works within a limited index, and the account manager might buy and sell pretty flippantly as your paycheck contributions come in. The pre-tax contribution and the employer match make funding the 401(k) easy; the management and the portfolio options make the plan a little underwhelming.

What are the other options worth considering? An IRA is almost universally the best bet. If you go with a good company (we usually promote Betterment), you can expect steady growth, transparency, and no sneaky fees. Start early enough and you’ll never feel like you were missing out on the employer contribution a 401(k) might have netted you.

In addition to the retirement account, there’s always the stock market. After all, the stock market is your retirement, we just tend to finance it through regulated accounts that don’t let us take out our money until we’re old. No one is stopping you from buying all the shares you like and then holding those until you retire. Enjoy economic growth and dividends, don’t sweat the setbacks, and join the ranks of investors like myself who see the stock market as an invaluable tool.

Even if you do have a 401(k) with an employer match, that shouldn’t be the end of your investment strategy. In a perfect world, you’d max out contributions to both the employer-sponsored plan and a separate Roth IRA, and then you’d have money left over to buy quality stocks. When you have multiple accounts getting funded, you give your capital the best chance to go to work.

You do not have to save through an employer-sponsored account. If you have questions about the 401(k), worry you might not be with the company long enough to get vested, or just feel like the account manager is too pushy, go with an IRA. The important thing is to save early and often. If you make consistent contributions to any account for 30 or 40 years, you’ll be in good shape.

What To Do When You Leave

In the wake of so many coronavirus related layoffs, lots of people are wondering what to do with a 401(k) that started at previous job.

When your career heads elsewhere, there are four things you can do with your 401(k). Two of them are acceptable options:

● Roll it into an IRA

● Roll it over to your new employer’s plan

And two are pretty bad ideas:

● Leave the account where it is and stop contributing

● Cash out and take the tax hit

A quick point on cashing out. When you get laid off or your company closes down, the circumstances feel really dire. It could seem like the only choice is to live off retirement money and accept the 10% loss for an early withdrawal. If at all possible, try to avoid this option. I can’t speak to everyone’s situation, but I know it’s incredibly difficult to rebuild retirement funds after emptying your account. I’ve seen too many people do this and then regret it mightily ten years later.

The other subpar option - leaving the money right where it is - isn’t going to cost you or outwardly hurt your account, but it sure won’t help. You want that money in a growing, active account, not under the control of a manager who’s now four or five degrees removed from you. The rollover process is simple and painless. There’s no good excuse for walking away from a job and walking away from your 401(k) money as well.

Which is it, then? New 401(k) or IRA? Pound for pound, an IRA delivers better returns and more options. When you get to roll thousands of dollars directly into an IRA instead of starting from scratch, it’s even more fun. The new 401(k) will be a lot like the one you left behind - with or without an employer match; decent contribution limits but more fees than an IRA. One overlooked benefit of 401(k) plans is that they offer protection from creditors and lawsuits. Anyone with above-average legal risk stands to benefit from that kind of security.

If you are one of many whose former employers had to close their doors due to the downturn, the vesting status of your 401(k) is kind of up in the air. If the company shuts its doors when you’re only 40% vested, that’s the unfortunate reality of how these accounts work. Times like these show that the whole “free money” aspect of a 401(k) often is too good to be true.

However much you have in your account and wherever you’re headed, moving the money into an IRA is generally the best bet.

How To Roll the Account Over

The “how” part is easy. Every financial advisor wants your money, so they’ll make the process as easy as possible. You won’t need to provide more than a few relevant details and the funds will migrate within a couple of weeks.

The big mistake is to cash a check that comes from a closed account. You have 60 days after an account closes to roll the funds into the new 401(k) or IRA. If you mess around and miss the window or create any sort of funkiness with your paperwork, the consequences can be very expensive. Ideally, the rollover happens without the funds passing through your hands. If a check does come to your mailbox, you should plan on getting that straight to your new account manager. Be sure to ask questions so you don’t make any small but costly mistakes.

Your only job when it comes to the rollover is deciding where you want your money to go. We’ve talked about Betterment, but maybe you’ve got a friend who’s an advisor and you’d feel more comfortable going that route. Perhaps you already have a brokerage account somewhere and you’d like to have everything under the same umbrella. Whatever you choose, ask the potential advisor about their fee structure so you know your cash isn’t getting pilfered.

If you have more specific questions about 401(k)s, don’t hesitate to ask. Sometimes they’re the best option, other times there are greener pastures, and that’s why it’s always important to do the research and figure out what’s best for you.

Above all, keep funding that retirement account. You can always upgrade a mediocre 401(k) to a solid IRA, so just keep those contributions going and build that wealth.

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