How does a 401k work?

In plain English, a 401k is an account you put money into that receives favorable tax treatment. Each year you can elect to contribute money to your 401k plan through payroll deductions. Elective deductions are usually specified as a percentage of your income, although some plans allow you to specify a dollar amount as well. The annual contribution limit is $18,000 in 2015 and 2016 (plus an additional $6,000 in 2015/2016 if the employee is age 50 or older). Do not go over this limit (some plans will not let you, and others will simply stop accepting contributions once you reach the limit).

 

401k plans come in two flavors:

  • Traditional 401k plan contributions reduce your taxable income. This is known as tax deferral – you are not taxed on the money you contribute now, but will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your 401k in the future.
  • If you contribute to a Roth 401k, contributions have already been taxed at your current marginal income tax rate. In exchange, all earnings may be distributed tax free if the distribution meets certain age and eligibility requirements. Note that not all 401k plans have a Roth option.

Which one do you choose? It depends on a lot of factors, but the big ones are:

  • Income – High earners are usually better off contributing to a traditional 401k, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth option, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.
  • Your guess about your future income tax rates – Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional 401k. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth option. Those that believe income tax rates will rise across the board in the future usually favor the Roth option.

Money you contribute to your 401k must then be invested in the funds your 401k provider offers you.

 

What should I do with my old 401(k)?

You usually have 3 options to choose from:

  1. Leave it where it is, managed by your old 401(k) company. (This assumes there is no periodic fee to maintain your account as a non-employee and that you have enough money in the account to meet any minimum requirements.)
  2. Roll it over into an IRA. (Note: this may not be a great idea for pre-tax 401(k) plans if you have a high income that is above the Roth IRA contribution limits and are planning to do a backdoor Roth IRA in the future.)
  3. Roll it over into your new company’s 401(k) plan. (This assumes they allow it.)

Make your decision based on which of the three options provides the best selection of investment options. “Best” is based primarily based on which has the investment options with the lowest expense ratios. Most of the time this will be option #2: an IRA with a low cost provider where you have access to index funds with expense ratios below 0.2%. However, if either your old or new 401k has a particularly good choice of low expense ratio index funds (below 0.1%) to choose from you may want to choose option #1 or #3. This is usually only the case with extremely large corporations.

Note that some 401(k) plans feature “force-out” provisions that will remove separated participants with a low-balance from the 401(k) plan. If your old employer’s 401(k) plan features a force-out provision, they may exercise it if your account balance is less than $5,000. If your account balance is below $1,000, your former employer may send you the entire balance in the form of a check; otherwise, your employer must exercise the force-out by rolling the money into an IRA on your behalf. If you have an old 401(k) and are planning on keeping your money in the plan (as per option #1), ensure that your balance is high enough that you cannot be forced out, or that your plan does not force out old participants. If you are planning a rollover (as per option #2 or #3), and your old employer’s 401(k) plan features a force-out provision, you may want to roll your balance out as soon as possible, to avoid your 401(k) balance going through the force-out process.

 

I have a bad 401k plan, can I roll it to an IRA now?

401k plans usually only allow rollovers upon separation from the employer that sponsors the plan. Some plans, however, have an “in-service rollover” provision that does allow participants to roll funds from a 401k to another qualifying retirement plan without separating from the sponsor. This is a plan-by-plan feature, so you need to check with your 401k administrator or human resources office to find out if your plan has it.

Do rollovers into my new 401k count against my annual contribution limit?

No. Rollovers do not count against annual contribution limits for your 401k or IRA.

What’s the best way to perform/initiate a rollover?

Starting in 2015 the IRS is instituting a “one rollover per year” policy regardless of how many IRAs you own. In context, this refers to a rollover when you, the account holder, receives a check and then redeposits the money into the proper account. It does not apply to trustee-to-trustee rollovers in which you never have to deal with a check and everything is handled by the gaining and losing financial institutions. Thus, do a trustee-to-trustee rollover whenever possible to avoid any potential complications with the IRS, losing the check, or accidentally taking a distribution when you don’t mean to.

What’s the best company to roll my 401k/403b/etc. to?

Vanguard, Fidelity, and Charles Schwab are generally the IRA providers with the lowest expense ratio funds to invest in.

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