UnderstandingYour 401(k)
It is the single most important account most people will ever own — and one of the least understood. Here is what the numbers-and-a-letter actually mean, and how to get the mostout of yours.
What is a 401(k)?
A 401(k) is a tax-advantaged, defined-contribution retirement account offered by most employers, named after the section of the U.S. Internal Revenue Code that created it. Contributions come out automatically through payroll withholding, and employer scan match some or all of what you put in. In a traditional 401(k), investment earnings are not taxed until withdrawal — typically in retirement. In a Roth401(k), qualified withdrawals come out tax-free.
The benefits
Retirement saving is a necessity, not a luxury — and the 401(k) is built to make it easy:
• Potentially free money. Many employers match your contributions.
• Easier to save when it's automatic. The money is deducted from payroll before you can spend it — you effectively train your self into saving.
• Tax advantages. Pre-tax contributions fund retirement and lower your taxable income today.
Extra benefits some plans offer
• Profit sharing. Some plans contribute an additional amount depending on the company's financial health — often in the0–6% range. Caveat: you may need to be actively contributing to receive it.
• Loans. Some plans let you borrow from your balance and repay yourself with interest via payroll. It can beat taxes and penalties in a pinch — but it is still generally not recommended.
Contributions: limits andtypes
The IRS sets anannual employee contribution limit, plus an additional catch-up amountfor those 50 and older; both are adjusted periodically, so confirm the currentyear's figures. The more important choice is which type of contributionto make:
• Pre-tax contributions come out of gross incomeand lower your taxable income now; withdrawals are taxed as income later(penalty-free after age 59½).
• Roth contributions (not offered in every plan)come out after tax — they reduce your paycheck more today — but qualifiedwithdrawals are entirely tax-free (also penalty-free after 59½).
The employer match
Employer matching contributions are always pre-tax — the IRS only allows employers to contribute that way. The guidance here is simple: contribute at least enough to capture the full match. If your employer contributes 3%when you contribute 6%, that 3% is an immediate 50% return on your money. Watch for a vesting period: leave the company too early and some of the employer's contributions may not come with you.
Investment options insidethe plan
The most common investment inside 401(k) plans is the mutual fund — a pool of investor money, typically invested in stocks and/or bonds, with the fee built into the price as an expense ratio. Your practical choice is usually between two approaches:
• Do-it-yourself (DIY): pick and manage the funds in your plan's menu. More control and often lower cost, but it takes time and research.
• Target-date fund: pick the single fund dated closest to the year you turn ~65. It automatically holds an age-appropriate mix and grows more conservative as retirement approaches — a path known as the glidepath. Simpler, at the cost of a somewhat higher expense ratio.
Which is right for you comes down to the time and interest you have (DIY) versus the convenience premium you are willing to pay (target date).
What happens to an old401(k)?
When you leave a company, you cannot contribute to that plan anymore. The account may still charge an administrative fee (often a flat dollar amount), and any outstanding plan loan generally becomes due — usually as a lump sum, since there is no paycheck to repay it from; unpaid amounts can be treated as a distribution with taxes and penalties.
You have fouroptions:
1. Leave it there. No action required — but easy to forget, and no new contributions.
2. Roll it into your new 401(k) — if the new plan accepts rollovers; check with the provider.
3. Roll it into an IRA — a current or new IRA can accept old 401(k) assets.
4. Take a full distribution — taxes and a penalty apply if you are under 59½.
Recap
• Use your 401(k) — it is the easiest on-ramp to retirement saving
• Get your free money: capture the full employer match
• Understand the contribution types and current IRS limits
• Pick an investment strategy — DIY or a target-date fund
• If you have an old 401(k), go find it and review your options
• When in doubt, get help from a fiduciary advisor
How IPM Advisory can help
IPM Advisory is a fiduciary advisory firm focused on financial educationand planning-first investing. If you would like help applying the ideas in thisarticle to your own situation, schedule a complimentary introductory meetingthrough our website.
