If you are working for somebody else and you have a 401(k) plan available to you, should you contribute? How much should you contribute? What should you invest in? Can you borrow against a 401(k)? What should you do with the 401(k) when you change jobs?
Should You Contribute To Your 401(k)?
A simple question with a complicated answer. Most employers offer a 401(k) with a company match. In other words, they usually match your contribution up to a certain percentage. They may match 50% of this. You will have to check with your plan to find out more. I would, at the very least, contribute enough to get your company match.
In 2020, you can contribute up to $19,500 to your 401(k) (IRS). However, your employer may have a maximum percentage you can contribute. Also, if you are over age 50, you can contribute an additional $6,500 for a total of $26,000.
It is important to note that some 401(k)s have a Roth 401(k) component. If it does, you can contribute after tax to your Roth 401(k). This pays taxes on the money up front so that when you withdraw it, the money is tax free. Company contributions are usually made pre-tax, as in not Roth.
If I were you, and I am not, I would take advantage of your employer 401(k) as much as you can. Do not consider your 401(k) contributions to be part of your savings goal (the 20% we previously talked about).
What Should You Invest In?
Employer 401(k)s usually have a limited selection of funds to invest in. If you are more than 5 years from retirement, I would go with the stock fund that has the best 5 – 10 year performance. Just the one. If you are within 5 years of retirement, I would probably pick a balanced fund or have half of your 401(k) in a fixed income fund. A bond fund would be fine.
When you get your paycheck, your 401(k) contribution is taken out. The percentage will be based on your gross pay regardless of whether it is a Roth contribution or not. Roth contributions will not have an impact on your taxes.
Your contribution goes directly into the funds you have selected. The great thing about investing this way is that you get the best prices over time due to dollar cost averaging. Dollar cost averaging is what it sounds like, you get today’s price each time you contribute so that when the fund declines in price you get a better price.
Regardless, your performance will be less than if you invested in individual stocks, but beggars can’t be choosers.
Can You Borrow Against A 401(k)?
You actually can, up to 50% depending on your plan. Check with your employer to see if they allow this.
Should you borrow against a 401k is perhaps a better question. Ok, I’ll just lay it out like this: If you borrow against your 401k and change jobs, whether on purpose or not, your 401(k) loan becomes taxable and includes a nice 10% tax penalty in most cases. This is the biggest risk with borrowing.
You can pay back the loan or roll it over separately, if you can and if it’s allowed, to avoid the tax issues. I did have a minor little tiff with the IRS over rolling over a loan balance separately, but it can be done. Make sure you know what you’re doing.
What Should You Do With A 401(k) When You Change Jobs?
I have had situations where I have left my 401(k) alone for a while. You can do that if you like. My personal preference, though, would be to roll it over to a brokerage IRA (or Roth IRA). IRAs have better rules, especially with minimum distributions, than 401ks do. Also… wait for it… you can invest the money any way you want if it is in your IRA brokerage account.
Now you can invest in your 10 individual stocks.
I wouldn’t leave a job just so you can roll your 401(k) into an IRA, but if you happen to make a move, why leave it in the 401(k) funds that underperform what you can do with individual stocks?
If this is your first attempt to invest, start out slow.
I am employed by my own corporation so I have a company-sponsored individual 401(k). I was investing in just IRAs for a while, but the $7000 limit per person was a bit low. My 401(k) is for when I want to contribute more. I can usually contribute to both the IRAs and the 401(k), and the 401(k) has a very large limit. Yes, I can contribute $26,000 as long as I made $26,000.
The maximum total contribution for a 401(k) is $57,000 for 2020. Above $26,000 is profit sharing and it can be no more than 25% of my gross pay. So if I make $50,000, I can contribute $26,000 and the company can contribute $12,500.
Because this is my own 401(k), I allow myself to invest in anything the brokerage account is allowed to invest in.