A comfortable retirement is the brass ring for many Americans. And one of the best ways to plan for retirement is to stash cash in a 401(k).
With a 401(k), you can designate a percentage of your income to be automatically deducted from your paycheck and earmarked for retirement.
It might seem straightforward, but 401(k) plans come with specific rules that impact how they are used and taxed. Over time, some misconceptions about 401(k)s have flourished. Here are eight myths that can trip you up.
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1. A 401(k) plan is always the best place for retirement savings
A 401(k) can be a great place to save for retirement. But that doesn’t mean it’s always the best choice in every situation.
For example, some people might prefer to split their retirement savings between an IRA (traditional or Roth) and a 401(k), since IRAs often offer a wider range of investments and greater control over fees.
Others might find that their workplace 401(k) does not offer a Roth option and thus might prefer to contribute to a Roth IRA over a 401(k).
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2. You can never take early withdrawals from a 401(k) plan
If you withdraw money from a 401(k) before you hit the age of 59 ½, it is usually classified as an early withdrawal. That can subject the withdrawal to both taxes and a 10% penalty.
However, there are exceptions where the 10% penalty does not apply. And even if the penalty does apply, you can still access your cash if you are willing to pay the fee, and the taxes.
You can also loan yourself money from your 401(k) without fear of penalties as long as you repay within the appropriate time frame, usually five years.
The bottom line is that you can make withdrawals if you must.
3. You will be in a lower tax bracket when you retire
Many people contribute to a 401(k) today in hopes of delaying taxes until they are in a lower tax bracket during retirement. But it doesn’t always work out that way.
Tax rates are low today by historical standards, but they might rise in the future.
Also, it’s possible that you will do so well as an investor that your tax rates will actually be higher in retirement, especially once you have to take the required minimum distributions beginning at age 73.
It’s possible your tax rate will be lower in retirement, but you shouldn’t simply assume that will be the case.
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4. 401(k) plans have almost no fees
Contributions you make to a traditional 401(k) can reduce the amount of federal income tax you owe, but that doesn’t mean your contributions are free from fees.
Many 401(k) plans are notorious for the fees they charge. The U.S. Department of Labor advises considering these fees before investing in your employer's plan.
5. You can't leave a 401(k) with a former employer
If you leave a company, you typically have the option to take your 401(k) with you and roll it over into an IRA. But in many cases, you are not required to do so.
When a plan sponsor allows it, you can leave the money in your old company's plan even if you no longer work there.
6. You can't contribute to both a 401(k) and an IRA
With this one, the devil is in the details.
The IRS is OK with a combination of savings strategies, allowing contributions to both a 401(k) and an IRA during the same year. However, you must adhere to contribution and deduction limits and follow the rules closely.
Some people might be more comfortable working with a financial advisor before trying this strategy.
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Giving yourself a loan from your 401(k) may not be the worst idea in the world, but it often is far from the best.
One downside of borrowing from a workplace retirement plan is that you lose the opportunity for investment growth.
Also, if you separate from service with your company, you might be required to pay back the entire loan in a relatively short period of time.
Bottom line
Contributing to a 401(k) plan can be a great way to set yourself up for retirement . Saving for retirement in this way is convenient, offers tax incentives, and often comes with employer matches.
However, not all the advice about 401(k) plans is accurate. If you are unsure of what is true and what is not, consider meeting with a financial advisor before making big money decisions.
Money tips that can work for everyone
No matter what your bank account balance is, there's always an opportunity to optimize and improve your finances. Here's a quick checklist of things you can look at today.
Focus on paying off your debt. Debt can hold you back from making progress with your overall financial well-being. Aside from cutting expenses, there are tools that can help you pay off debt faster like balance transfer credit cards and debt counseling.
Earning extra income can give you breathing room. If finances are tight, earning some extra money to supplement your income can make a huge difference. A new job is one option to consider, but if you're not ready to make a big change or already retired, a part-time side job could be a better choice.
Cut your expenses. It sounds painful and so not fun, but it doesn't have to be. Take a look at your biggest expenses because that's where you'll probably find the biggest savings. For example, auto insurance rates have been soaring so shopping around for a new insurance company can be the fastest way to cut your bill. Also, look for ways to cut your grocery bill (despite rising inflation).
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