Today about 45 million individuals are participating in a 401(k) plan. Many additional individuals have a 401(k) available to them but don't participate. Whether you are currently participating in a plan or not, the following tips from Spectrem Group's research should help you to understand the correct choices for you.
The first thing employees should know is if your company offers a 401(k) plan, you should be contributing. No discussion. No ifs, ands or buts. Unless you are independently wealthy, the 401(k) plan is a critical tool to help you save for retirement.
Each paycheck employees determine the amount of money they want to have placed in their 401(k). The amount you choose is called your deferral rate. Average deferral rates are historically around 6%. Your plan may limit the amount you are able to save. When you turn 50, however, you are allowed to put in even larger amounts to "catch up" for what you failed to save at a younger age.
More than half of plan sponsors (your employer) will match the amount you put into the plan up to a certain amount. Matches range from 100% to 25%. Usually they cap out at 5-6% of salary. This is free money, to some extent. If you don't put money in the plan, you won't get this money from your employer otherwise.
Another important point, all of this money grows tax free until you take it out of the plan. Hopefully you won't take it out until you are ready to retire. Retirement age is generally defined in your plan document, or just ask your employer. (65 is the most common age.)
There are exceptions to taking the money out of the plan. Most plans allow for loans. You can usually get a loan by going online to your account and applying for the loan. In many cases the plan sponsor (your employer) may have to approve the loan. You can take up to 50% of your account balance for the loan. The loan will be repaid from your future contributions. You will receive a promissory note and an amortization schedule. The loans must be paid back within 5 years. You can also take a hardship withdrawal. The hardships must be approved by your employer and must be taken for specific reasons.
Determining how to invest your plan assets is another critical decision. Your employer or the plan provider will provide you with a quiz you can take to determine your own risk tolerance. Risk tolerance is the amount of principal you are willing to risk to arguably achieve greater returns. Until the 2008 market crash, many individuals did not realize that they could lose money in their 401(k) plans. The assets, however, are generally invested in mutual funds and are subject to the overall market. Some funds, however, are less likely to crash but do provide a lower return. The plan sponsor and plan provider will give you information to determine the right investments for you.
Defined contribution plans, such as 401(k) plans, are likely to remain the primary tool for employees to save for retirement, barring some large legislative change. You should take advantage of the materials offered to you to ensure you understand your plan and make the most of your savings.