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When times are tight, that money sitting in your 401(k) can look very tempting. If it's the difference between paying hospital bills, getting out of crushing debt or fixing a hole in the roof, it can be hard not to dip in. But is it always a smart idea? That's just one of the several most frequently asked questions about 401(k)s. Here's the answer to that and other common 401(k) questions.
Q: Can I borrow from my 401(k)?
A: You can, but it’s not generally a good idea for several reasons. If you leave a company, you typically have to repay the loan within 60 days. If you don’t have the money because you’ve used it for something else, it will be treated like a withdrawal – meaning you’ll pay income taxes and penalties. That can cost 30 to 40 cents on the dollar. Ouch. The other reason, though, is that when your money is not in your 401(k) it’s no longer growing tax deferred. The S&P 500 is up more than 90 percent over the last 5 years. That’s a lot of growth to have missed.
Q: If my employer isn’t matching my contributions should I still put money into a 401(k)?
A: Generally, yes. 401(k)s work because they get around the human factor. They swipe your money out of your paycheck before you have a chance to see it or touch it. If you do want to tap it before you hit retirement age you face nasty taxes and penalties, so you’re more inclined to keep your hands off. We need that automation working in our favor. You can also put much more money into a 401(k) than you can into an IRA or Roth.
Q: I’m leaving my job, what should I do with my 401(k)?
A: Generally, you have four choices: You can cash out and pay income taxes as well as a 10 percent penalty if you’re not 59 ½. Let’s take that bad option off the table. That leaves you with three more. You can leave the money in your former employer’s plan, roll it into your new employer’s plan, or roll it into an IRA.
Many people will tell you that an IRA is absolutely the way to go – but it isn’t always. Although you have a wider variety of investments with an IRA, the cost may be higher. IRA’s frequently charge an annual, not-too-high maintenance fee, but the expenses associated with buying the individual mutual funds you’re likely to invest in may be much higher. When you’ve got the money in a 401(k), it’s like being in a group health insurance plan – you have the purchasing power of a an entire plan behind you. You’re not operating on your own. The thing to do is compare both the costs of your old plan, new plan and an IRA and the costs of the investments you’re interested in. And if you DO roll your money into either an IRA or your new plan, make sure the transfer happens directly. You do NOT want a check being cut to you.
Jean also answered viewers 401(k) questions in a live Twitter chat using #getaplan.
Q: I’m now being offered both a Roth 401(k) and a regular one – which is best?
A: You’re not alone. Roth 401(k)s have only been around since 2006, but more than half of employers now offer them. A quick reminder of the difference between Roth and Regular – it works the same way with 401(k)s as it does with IRAs. With a Roth, you pay taxes on the money before you it goes into the account. But you don’t have to pay taxes upon withdrawal. With a traditional or regular 401(k) you put in pretax money -- and get a tax deduction for doing so -- and you pay taxes when you pull the money out in retirement at whatever your tax rate is then. So, if you expect your tax rate to be higher in retirement (or if you expect tax rates to go up) putting some money in a Roth is a good idea. Similarly, if you’re young and have decades for the money to grow tax-free, Roths work in your favor. (When you’re young, your likely not at your peak earning potential, which means you don’t lose as much on the tax deduction.) One thing to keep in mind: It’s not bad to split the difference. At retirement, it helps to have some money you’ve already paid taxes on and other money that is tax-deferred. If you’ve already got a Roth IRA, using a traditional 401(k) as a supplement is a good way to go. If you make too much money ($129,000 for singles, $191,000 for married couples) to qualify for a Roth IRA, a Roth 401(k) is nice work-around.
Q: How much should I be putting into my 401(k)?
A: More employers are “defaulting” their employees into their 401(k) plans. The problem is, they put them in at a contribution level – typically – of just 3 percent. That is not going to give you enough money to retire. Instead, if you earn less than $50,000 you should try to save between 9 percent and 12 percent of your income including what your company matches. If you earn between $50,000 and $100,000 you should be saving 12 percent to 15 percent including what your company matches. And if you earn more than $100,000 you want to be saving at least 15 percent (more if you can) including what your company matches. Don’t try to do this all at once. Research has shown that we can save 2 percent more than we are saving now and not notice it. So nudge your contribution up by 2 percent now and then do that again every six months to a year until you get where you need to be.