5 Misunderstood Facts About 401(k) Accounts -- Are You Costing Yourself Money?
Is what you don't know about 401(k)s costing you big in retirement?
A 401(k) — and Roth 401(k) — are employer-sponsored retirement plans that come with tax benefits. They’re often seen as simple retirement accounts, but there’s more to it than most Americans realize.
To help Americans better plan for retirement, experts shared some of the most commonly misunderstood aspects of 401(k)s.
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1. Contributions Don’t End With an Employer Match
“A contribution to a 401(k) or Roth 401(k) does not end with an employer's match; it continues until the annual contribution limit of $24,500 is reached,” said Cody Schuiteboer, president and CEO of Best Interest Financial.
According to Schuiteboer, the match typically amounts to 3% to 6% of salary in most companies.
“Individuals with $120,000 in annual income do not realize they can put much more ($19,000 on average) tax-free into a 401(k) and accumulate millions of additional dollars in their account in case of a 25-year-long career,” he wrote in an email.
2. A Traditional 401(k) Won't Be Taxed
“One topic is that a traditional 401(k) won't be taxed. People are often surprised to find this out,” said Chad Gammon, CFP, RICP, EA and owner at Custom Fit Financial.
A traditional 401(k) is a tax-advantaged workplace retirement account, reducing your taxable income for the contribution year. However, you are taxed when it’s time to start withdrawing. A 401(k) withdrawal is considered taxable income and is taxed at your ordinary income rate.
3. Automatic 1% Annual Increase
“When I signed up for my 401(k) plan 18 years ago, I noticed a box to check that said, ‘automatic 1% annual increase’. I checked it and I have never unchecked it,” said Barry Cothran, president of Vision and Hope. “That one little box was the difference between having retirement savings and having real wealth.”
This is a feature that allows employees to automatically increase their contribution percentage.
“Most plan holders revisit their plan documents on an infrequent basis," Cothran said. "If they miss that magical little box when they first sign up, they may not notice it again for years."
4. Not Understanding Roth 401(k)s
Gammon noted that he sees a lot of people invest in Roth 401(k)s without understanding why.
“They've just heard that it is better to invest there than a traditional 401(k)," he said. "This may not be the case long-term and they should look at their current tax rate vs. projected tax rate when retired."
The biggest difference between a Roth 401(k) and a traditional account is that Roth 401(k) contributions are made with after-tax dollars. This means when you make withdrawals in retirement, it’s tax-free.
“This potentially could lead to investing in a traditional 401(k) now if current tax rates are projected to be higher than when retired,” Gammon added.
5. Required Minimum Distributions
An expensive mistake that Brennan Kolar, founder at Atlas CPA Index, sees people make is thinking their Roth 401(k) has required minimum distributions (RMDs) you must start taking at age 73, like a traditional account.
“The SECURE 2.0 Act eliminated RMDs from Roth 401(k)s starting in 2024,” Kolar said. “Account holders can now leave the balance compounding tax-free for life and pass the entire account to heirs without ever pulling a dollar out themselves.”
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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