Paying more attention and managing your 401(k) can potentially make and save you a lot of money toward your retirement. However, like most Americans who own a 401(k), life often gets in the way and we often leave our 401(k) on cruise control.
But ask yourself this important question…
How much time did you spend researching your last vacation? Two, maybe three weeks? What about when you bought your last car? That amount of research can take a up to a year.
Now, think about how much time you spend researching the most important financial aspect of your life. How much time you spend researching what is happening with my 401(k)? You’re not alone if you answered, “not much.” But don’t beat yourself up. Managing your 401(k) can seem daunting due to outdated platforms and complex processes.
The good news is with just a little 401(k) education, you could not only increase your ability to protect your retirement plan during downturns but put your nest egg in a position for significant growth toward your retirement.
The best place to start is with the basics and reading, A Simple Guide to Managing your 401(k).
What is a 401(k) Plan?
A 401(k) is a retirement savings plan that gives employees the chance to send a portion of their paycheck into long-term investment funds. One of the benefits of a 401(k) is that the employer may decide to do a limited match of the employee contribution.
While the employee has control over how much they decide to invest into their 401(k), there are specified limits of total annual contribution. In 2020, the joint contribution limit for employee and employer was $57,000. It is a little higher for those employees aged 50 and older.
An employer that offers a 401(k) plan offers a choice of mutual funds and sometimes index funds. There are close to 10,000 total mutual funds in America, but the options are typically limited in a 401(k). These funds can offer a variety of investment options, both by sector (technology), market cap (large cap, small cap, etc, bonds, real estate and more.
When you first opened your 401(k), you may have allocated your investments into a single fund such as a low-risk, large cap fund. However, by not taking a direct interest into managing your 401 k), you could lack the diversification needed to hedge your down-side and potentially make greater returns.
The first step in taking a direct role in managing your 401(k) is understanding your risk.
What is Your Actual Risk?
If you have a 401(k), you probably went through the process of trying to identify which mutual fund suited your risk level. In the end, you probably got grouped into a few mutual funds based on your age – If you are younger, you can take on more risk, if you are older, you take on less risk.
This generality is fine for those just starting to save for retirement but when it comes time to become a serious investor, knowing your risk tolerance is crucial.
Investing is inherently risky. And risk is primarily applied to the investor not the stock. Risk tolerance is how much risk an investor is willing to absorb to increase potential return.
Obviously, some of us are willing to take greater risk than others, so grouping investors by age is not exactly the most accurate way of defining an individual’s risk tolerance.
There are several online assessments that can help define your individual risk tolerance but at the very least, you need to consider several hypothetical scenarios in order to determine how much risk you are willing to take:
- Your Future Priorities: Family, home, business.
- Your Emergency Savings: If you fell off your roof tomorrow and don’t have health insurance, would you have enough in the bank to cover medical cost?
- Your Investment Objectives: Are you saving purely for retirement or do you want to buy a boat next summer?
When it comes to 401(k), taking the time to know your true risk level could put you in a position for a greater return, not just on your 401(k) but any self-directed portfolio you might own as well.
Managing A Self-Directed 401(k)
There are always going to be pros and cons to taking greater control over your 401(k) but if you decide to take an active role in managing your 401(k), the benefits can often outweigh any drawbacks.
Pros to Managing a Self-Directed 401(k):
- Greater control over your financial destiny: Having a complete understanding on how you are pacing to your retirement can give you a tremendous amount of peace-of-mind. Managing your 401(k) can give you a holistic picture of your finances at large. This may allow you to make better financial decision overall when it comes to expenses and budgeting
- Access to Higher Quality Investment Options (and more of them): There are over 10,000 mutual funds in the United States, but your employee managed 401(k) may offer only a limited amount. With a self-directed 401(k), your investment options greatly increase, giving you the ability to further diversify and track better investment options.
- Sharpen your Investment Knowledge with lower Risk that individual stocks: Mutual funds can be a great way to further your investment acumen without having to worry about the performance of an individual stock. Managing your funds, can give you a broader sense on how the markets and sectors perform at large and may give you great stock investing ideas in other self-directed portfolios you manage.
Cons to Managing a Self-Directed 401(k):
- Time and Effort: If you have little investment knowledge, catching yourself up before managing your 401(k) will take time and effort. With the balance of work, family, self-care, etc… it can take quite a bit of time. However, this is not a timed quiz, so if you decide to learn about investing, you can go at your own pace
- Additional Fees: Those who decide to move outside of the funds set by their employers or trade too many times, may encounter additional fees. These fees vary and you should take the time to understand any that may apply before you manage your own 401(k)
The bottom line at Wealthplicity is that we encourage everyone to become more financially literate and empowered. There are many benefits to managing a self-directed 401(k) but taking the time to understand the pros and cons, retirement options, fees and investing in general can go a long way to ensuring a safe and successful retirement account.
Withdrawal from 401(k)
There can be many reasons why you may need to borrow a loan from your 401(k). And if you have a plan to pay that loan back in under a year, it can be an excellent option.
Let’s face it. Over the course of your life, there are going to be unexpected surprises where you may need an immediate cash infusion. Borrowing from your 401(k) can be inherently less risky and less expensive than seeking out a personal loan or payday loan which could have astronomically high interest rates.
Taking out a loan from your 401(k) is not taxable unless you violate the terms of the withdrawal. It also has zero implications to your credit rating. In addition, taking out a loan from your 401(k) is a lot easier and faster than having to apply for a payday or personal loan. There isn’t a cumbersome application process or invasive credit checks to go through.
The repayment process can be a lot more efficient as well. For most loans, you can repay through deductions right from your paycheck on a set schedule. Though, this deduction occurs after-tax, not pre-tax like your regular contribution. Most loan plans allow up to a five-year pay back schedule.
What you should know about Withdrawal from a 401(K):
- Borrow up to $50,000 or 50% of your 401(k) balance, whichever is higher
- You can select to have automatic payments deducted from your paycheck or pay it back through another account on a set schedule
- You may not be able to contribute until you have paid back your loan
- The loan will not be taxable unless you violate the terms of the loan
Rolling Over your 401(k)
Many Americans don’t plan on spending 40 years in the same job. More power to those who do, but more than likely, you are going to have a different job at a different company sometime in your career. When this occurs, knowing how to rollover your 401(k) can save you time and money.
When you decide to rollover your 401(k), you have two options: direct and indirect. A direct rollover is the easiest and most efficient rollover. This is when you transfer your entire account without any tax or penalty. Simply contact your old 401(k) admin and facilitate a direct rollover from the old plan to the new one. Or, that admin can send a check that you give to your new 401(k) admin.
An indirect rollover assumes you are cashing out your old 401(k) since it requires a check to be made out in your name. With an indirect rollover, a mandatory tax will occur, and the fund will withhold 20% of the total funds for federal taxes. You have 60 days to deposit the remainder in your new 401(k) plan and you will still have to report the withheld taxes on your tax return.
While a direct rollover is the safest and most efficient, make sure you fully understand your new 401(k) plan before you do so. You usually have a good amount of time before you have to rollover your plan and taking the time to know what you are getting into can greatly benefit you. Most companies have experts who can help you understand the new plan and the funds available.
Again, if you take time to educate yourself and become familiar with investing at large, you can feel confident in managing your 401(k) and rest easy knowing you are in control of your financial destiny.