Increasingly, investing in a 401(k) plan is the primary way workers prepare for retirement. While all 401(k) plans offer tax breaks to retirement savers, many other features of these retirement accounts differ, sometimes significantly, by employer. Here are some key pieces of information you should know about your 401(k) plan:
Eligibility date. Only about half (55 percent) of 401(k) plans allow new employees to immediately begin contributing to the 401(k) plan, according to a recent analysis of over 1,700 401(k) plans administered by Vanguard with more than three million participants. Other companies require recent hires to wait two to three months (15 percent) or even a full year (15 percent) before they can begin contributing to the retirement plan. Some 29 percent of employers automatically enroll workers in the company 401(k) plan unless they take action to opt out.
Matching rate. The most common 401(k) match is 50 cents for each dollar contributed up to 6 percent of pay, but only 23 percent of employers provided this exact match formula. Vanguard administered more than 200 different match formulas in 2011. The median 401(k) match offered by employers is 3 percent of pay, and half of employers require workers to save 6 percent of pay to capture the entire match. Many companies have a waiting period before employees become eligible for a 401(k) match, profit-sharing, or other types of employer contributions to retirement accounts. Almost a third (32 percent) of employers require workers to remain with the company for a year before the company will match any retirement account contributions. Only 44 percent of 401(k) plan sponsors immediately begin employer retirement-account contributions for new employees.
Vesting schedule. Even after your employer makes a contribution to your 401(k) account, you don't get to keep it until you are vested in the retirement plan. Less than half of plans (45 percent) immediately vest all 401(k) participants in the plan. Some employers don't allow workers to keep any of the 401(k) match until they have been with the company for a specific number of years. For example, 11 percent of employers fully vest participants in the plan after three years of service, and if workers leave before then, they don't get to keep any of the match. Other employers allow workers to keep a gradually increasing proportion of the match based on their years of service. Many companies don't fully vest workers in the 401(k) plan until they have been with the company for five (18 percent) or six (14 percent) years. "If you have worked for four years and you will get it all at the fifth year, unless there is some other major situation, try to stay around until it is totally vested," says Stephen Madeyski, a certified financial planner and founder of Stephen Madeyski Financial Planning in Albuquerque.
Contribution limits. The contribution limit for 401(k)s, 403(b)s, and the federal government's Thrift Savings Plan is $17,000 in 2012, up from $16,500 in 2011. Workers age 50 and older can also make catch-up contributions worth up to $5,500.
Roth option. Almost half (46 percent) of 401(k) plans allowed workers to make Roth 401(k) contributions in 2011. Roth 401(k)s allow employees to contribute after-tax dollars to a 401(k) plan. Distributions in retirement, including growth in the account, are tax-free. In contrast, traditional 401(k) plans give you a tax break in the year you make a contribution, but income tax is due when you withdraw the money. Investing in both types of accounts can add tax diversification to your portfolio, which gives you additional flexibility in retirement. "We want to make sure people have diversification across assets, but also diversification across types of accounts," says Matthew Murphy, a certified financial planner and principal of Murphy Capital Advisors in Glendale, Ariz. "You want to make sure not all your money is in a 401(k) plan. You want to make sure some is in a Roth."
Asset allocation. In 2011, 401(k) plans offered an average of 19 investment options, and the average investor used three of them. It's important to pick a mix of equities and bonds that suits your risk tolerance. "Stick with an asset allocation you are comfortable with and at least once a year, review your 401(k). If your stock portion has outperformed, then you rebalance back to your target allocation," says Madeyski. "This way, you don't let your emotions control your investing in your 401(k) and you are selling high and buying low in the sector that has underperformed."
Plan costs. A variety of fees are deducted from the money you deposit in your 401(k) plan for recordkeeping, investment management, and other costs associated with the plan. In 2012, 401(k) participants will receive new information about the fees deducted from their account, thanks to new Department of Labor rules. "Take a look at the investment fees associated with everything on the menu of investments available. The management fees are going to be disclosed as the expense ratio for each of the investment options in the plan," says Peg Eddy, a certified financial planner for Creative Capital Management in San Diego. "An actively managed mutual fund, which means a manager is buying and selling, is going to have a higher cost generally than an index fund."
How to rollover without tax. Every time you change jobs, you need to decide what to do with your old 401(k) plan. You can leave the money with your former employer or roll it over to an IRA or your new employer's retirement plan. If you decide to move your money, ask your financial institution to directly deposit the money in the new account you select. This allows you to avoid having 20 percent withheld for income tax. "If you are given a check and the check is made out to you personally, then that is counted as a distribution and could be taxable," says Madeyski. "If you are sent a check made out in your name, then send it back and ask them to make it out to the rollover IRA custodian."
Date early withdrawal penalty ends. Retirees who leave their job during the calendar year they turn 55 or later can take 401(k) withdrawals without having to pay the 10 percent early withdrawal penalty. However, if you leave the job sponsoring your 401(k) plan at age 54 or earlier, you will generally need to wait until age 59 1/2 to take distributions without a penalty.
When to take money out. Withdrawals from 401(k)s become required after age 70 1/2. The first required minimum distribution is due by April 1 of the year after you turn 70 1/2, and subsequent withdrawals must be taken by December 31 each year. The penalty for failing to withdraw the correct amount is a 50 percent excise tax on the amount that should have been distributed. People who delay retirement past age 70 1/2 (and who don't own at least 5 percent of the company sponsoring the plan) can delay 401(k) distributions from their current 401(k) plan until April 1 of the year after they retire.
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