At a time when most people don't have a traditional pension, growing and then protecting your 401(k) balance is essential to a secure retirement. Pay close attention to 401(k) rules to make sure fees, taxes, and other mistakes don't unnecessarily reduce your 401(k) balance. Here are 10 ways to make the most of your 401(k) plan:
Don't accept the default savings rate. New employees are increasingly likely to be automatically signed up for a retirement account at work, most often by having 3 percent of their pay deposited in their company's 401(k) plan. But saving 3 percent of your salary, while certainly better than no savings, may not be adequate to maintain your current lifestyle in retirement. "For a lot of people, that is not going to be enough," says Michele Clark, a certified financial planner for Clark Hourly Financial Planning in Chesterfield, Mo. "When you get a raise, save 1 percent more every year until you can get up to hopefully 20 percent of your pay."
Get a match. The most common 401(k) match is 50 cents for each dollar saved up to 6 percent of pay. If your employer offers a 401(k) match, make sure you save enough to take advantage of it. Capturing a 401(k) match is one of the fastest and most painless ways to boost your 401(k) balance.
Stay until you are vested. You won't get to keep the 401(k) match from your employer until you are fully vested in the 401(k) plan, which can sometimes take as long as five or six years of service at the company. Some employers allow people who leave before they are fully vested to keep a portion of the match based on their years of service, while other companies require workers to forfeit the entire match. It can sometimes be worth thousands of dollars to continue to work for a company until you are fully vested in the 401(k) plan. "If you are in a miserable employment situation or have a life-changing opportunity to go somewhere else, maybe you have to sacrifice the unvested portion," says Joel Kelley, a certified financial planner for Woodstone Financial in Asheville, N.C. "If you are considering a lateral move career-wise, you should definitely take that into account."
Maximize your tax break. Traditional 401(k) plans allow you to defer paying income tax on the money you save for retirement. Investors can contribute up to $17,000 to a 401(k) plan in 2012, up $500 from 2011. And after age 50, the limit jumps to $22,500. Low-income workers who earn less than $28,750 for singles, $43,125 for heads of households, and $57,500 for couples in 2012 and save in a 401(k) plan can additionally claim the saver's tax credit, which is worth up to $1,000 for individuals and $2,000 for couples. Contribution limits for 401(k)s and the saver's credit income threshold are generally adjusted each year to reflect inflation.
Diversify with a Roth. A growing proportion of employers now offer a Roth 401(k) option in which workers can save after-tax dollars, and distributions are tax-free in retirement. A Roth 401(k) generally offers the biggest benefits to young and low-income workers who expect to be in a higher tax bracket later on in their career, but can also add tax diversification and flexibility to the portfolios of people closer to retirement.
Don't cash out. Most workers switch jobs several times over the course of their career, which means they need to decide what to do with the 401(k) balance at their former employer. It can be tempting to withdraw the cash, but workers who withdraw money from their 401(k) account before age 59½ face a 10 percent early withdrawal penalty and income tax on the amount withdrawn. Early withdrawals also cause you to miss out on valuable compound interest that is essential for building a large nest egg. "This money needs to be put away for retirement, and that's all it needs to be used for," says Carolyn McClanahan, a certified financial planner for Life Planning Partners in Jacksonville, Fla.