Your 401k Playbook: Start Now, Stay Invested, Avoid Penalties

Mr. Cook, my high school Accounting teacher, taught me about Individual Retirement Accounts (IRA) when I was seventeen years old.  I immediately walked into my local bank branch and asked to open an IRA.  I was denied!  Now, I know that the reason was that minors were not allowed to legally sign binding financial contracts, even though the IRS allowed minors to own IRAs.

When I worked part time at Arthur Andersen after high school, I started participating in our 401k plan at nineteen years old.  Since then, I have been contributing to 401k plans and IRAs as much as I could - often contributing the maximum allowable amounts.

At the time, I didn’t understand the time value of money or even the concept of retirement.  But Mr. Cook made an impression on me that I should start saving for retirement as young as possible, so I did!

Note:  Minors can now open a Traditional or Roth IRA, but it must be set up as a Custodial IRA managed by an adult. The minor legally owns the assets, but an adult custodian must oversee the account until the minor reaches the age of majority (usually 18 or 21, depending on the state).

Start now

Time works to your advantage in retirement savings.  When I set up 401k plans for my tech startups, I set up auto enrollment so employees start saving without extra steps, auto escalate so their savings rate increases 1% every year, and no minimum age or waiting period to participate so employees can build the habit as soon as possible.

If an 18 year old saves $20 per week ($80 per month) and increases their savings by 3% every year, they would have $800K by the time they turn 70 years old assuming 7% annual rate of return.  In contrast, a 45 year old investing at the same amount ($49 per week or $197 per month) would have $215K by the time they turn 70 years old.

Know your investments

Many 401k plans will automatically invest your money in lifestyle funds (aka target date funds) based on the year you plan to retire.  Lifestyle funds invest in a group of funds in various asset classes (stocks, bonds, and cash) that automatically adjust their risk profile as your target retirement date approaches.  The fund automatically shifts from a growth-oriented (stock-heavy) strategy to a conservative (bond-heavy) strategy as your retirement year approaches.

You can change your investment selections by logging in to your retirement plan account.  You may select a lifestyle fund with an earlier or later retirement year based on your personal preference and/or risk tolerance.  Or you may opt out of lifestyle funds and select your own mix of investments.

Watch your expenses

Every fund offered by your 401k plan has an expense ratio - an annual fee a fund charges investors to cover operational costs and  is automatically deducted from the fund's returns.  You can easily view the fund fact sheet and prospectus on your plan’s website, so you can compare funds based on risk, return and expense.  For example, the Fidelity Freedom® 2040 Fund has an expense ratio of 0.66%.

Your employer’s 401k plan has administration expenses for Third Party Administrators, Recordkeepers, and Advisors.  Depending on your employer, the company may cover these expenses or pass them on to 401k participants.  This is an important consideration if you are deciding to rollover your 401k balance with your prior employer to your current employer’s 401k plan or your own rollover IRA.  The Advisor fee is based on a percentage of your total assets so this fee will increase if you rollover your 401k balance.

In contrast, a rollover IRA will not have these 401k administration expenses.

Note: Annual administrator fees at a former employer were TPA base fee of $2K + $30 per participant; Recordkeeper base fee of $1.5K + $50 per participant; and advisor fee of 0.75% of assets. The employer may choose to absorb these costs or pass them on to participants. In the latter case, the base fee is distributed across all participants in the plan (eg: ($2000 TPA + $1500 Recordkeeper) / 50 participants = $70 per year per participant).

Do not withdraw your 401k funds

Research by the Harvard Business Review and the Employee Benefit Research Institute shows that roughly 40% of workers withdraw funds when leaving an employer.  Unless the saver is over age 59 1/2, early withdrawals are subject to a 10% federal penalty and state/federal income taxes, as well as lost wealth from missed investment earnings.

It is important to know your options after you leave your employer.  Most plans have thresholds for allowing you to keep the funds in the company plan or forcing you to withdraw the funds.  For the latter, unless you initiate a rollover to another 401k plan or your IRA, the plan will issue a check for your 401k balance less penalties and tax withholding.  Immediately, you lose 20% or more - depending on your tax bracket - of your 401k balance!

Employees have told me that their 401k balance was too low to bother rolling over into another account.  I disagree! Consider that a 30 year old with a $5k 401k balance would have $75k upon retirement at 70 years old, or $45k at retirement with a 401k balance of $3k.  Keeping your 401k funds invested can make a big difference in your future retirement.

If you set up a rollover IRA once, you can keep rolling over your 401k balances to this same IRA for future employers’ plans.  You also have the added benefit of having all of your retirement funds in one account.  When you retire, you do not need to keep track of your accounts from prior employers.

When it comes to your 401k accounts - Start early.  Stay invested.  Resist withdrawals.