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401k Investments

401(k)'s are the new "Company Pension Plans".

Primary Investment Vehicle

According to Money Magazine, Americans have amassed $5.9 trillion in 401(k)s and similar plans.  Now retiring baby boomers are beginning to withdraw their money to fund retirement and other investment alternatives.

If your employer offers a 401(k) plan, this should be your primary investment vehicle for retirement savings.  Money is automatically debited from your paycheck and invested in a 401(k) account either pretax (traditional) or after tax (Roth), or a combination of both.  Pretax means that you will not pay Federal tax, and in most locations state and local tax, on this part of your income until the money is withdrawn, usually in retirement.  You can save from 1% to 50% of your eligible pay into a 401(k) plan, where eligible pay is generally defined as your regular base pay plus overtime, shift differential, cash bonuses, incentive awards and commissions.  In 2025, eligible pay cannot exceed the IRS maximum of $350,000, and total employee contributions cannot exceed $23,500.  If you are age 50 or older, you can make additional (catch-up) contributions of up to $7,500 in 2024, bringing your total contribution to $31,000 (see table below).

Maximum Cointributions

Here are the allowable 401(k) contributions for years 2012 through 2025.  Catch-up Contributions are available for people whose age is 50 and above.

Year Normal Catch-up Total
2012 $17,000 $5,500 $22,500
2013 $17,500 $5,500 $23,000
2014 $17,500 $5,500 $23,000
2015 $18,000 $6,000 $24,000
2016 $18,000 $6,000 $24,000
2017 $18,000 $6,000 $24,000
2018 $18,500 $6,000 $24,500
2019 $19,000 $6,000 $25,000
2020 $19,500 $6,500 $26,000
2021 $19,500 $6,500 $26,000
2022 $20,500 $6,500 $27,000
2023 $22,500 $7,500 $30,000
2024 $23,000 $7,500 $30,500
2025 $23,500 $7,500 $31,000

Investment Growth

Most employers will contribute money to your 401(k) account based on your contribution.  They typically match dollar-for-dollar your contribution up to a maximum percentage.  Your money and your employer’s contribution are invested in various funds including capital preservation (fixed) funds, mutual funds, and company stock.  Mutual funds generally include index, actively managed and target retirement date.  The funds right for you and your level of investment diversification depend on a variety of factors, including personal risk tolerance, age and investment goals.

401(k) Decisions at Retirement

According to benefits consultant Aon Hewitt, the average 401(k) balance for workers 60 or older making $100,000 or more a year stood at $414,000 at the end of 2013.  In the opinion of Money Magazine, "deciding what to do with that money may be the most important financial call you'll ever make."  Because of the value of your 401(k) and its role in funding your retirement, if you make a wrong decision, it's difficult to recover.  While you are still working, your constant steam of earned income softens any bad financial decision.  However, once you retire, what you have is all you have.  Therefore, you need to protect, use wisely and grow your investments.  The following sections will help you decide what to do with your 401(k) when your contributions and employment end.

Distributing 401(k) Funds

When you retire or leave your job to work at another company, the money in your 401(k) account (employer’s contributions, your contributions and investment growth) can be:

  1. Left with your employer,
  2. Transferred to a qualified retirement plan with your new employer (if you're still working),
  3. Distributed directly to you, or
  4. Rolled over into an Individual Retirement Account (IRA).

You can almost always keep your 401(k) with your employer if it's worth more than $5,000, and it's very common for employees to roll their 401(k) over to their new employer's plan.

Any money held in a pretax account (e.g. 401(k)) will be taxed as ordinary income, with a mandatory 20% withholding, when it is withdrawn and not rolled over into another plan. In addition to ordinary income taxes, you may owe a 10% penalty tax on the taxable portion of any distribution you receive before you reach the age of 59 ½. Because of the tax consequences, which may include pushing you into a higher income tax bracket, you should either leave the 401(k) with your employer or roll it over to another qualified plan/product.

Partial 401(k) Distributions

If you elect to remove your 401(k) when you leave your job, it's almost always done as a lump-sum; however some employee plans allow for partial distributions.  Partial Rollovers may be advantageous under the following circumstances:

  1. Your 401(k) has certain excellent investment options that are not available to retail investors, but the rest of the investment options are not very good. In such cases, it can make sense to keep the excellent investments in the 401(k) and roll everything else out of the account to an IRA.
  1. You retire between ages 55 and 59 ½. In these cases, due to a separation from service in or after the year in which you turn age 55, you would have penalty-free access to the 401(k) money, but because you’re not yet age 59 ½, you might not have penalty-free access to traditional IRA money. As a result, you may want to roll over part of the 401(k) while leaving enough money in the 401(k) to satisfy living expenses until you reach age 59 ½.
  1. You want to take advantage of the "Net unrealized appreciation" rules.  If you have appreciated employer stock in your 401(k), you can roll everything except the appreciated employer stock into an IRA, and, in the same year, do an in-kind distribution of the employer stock to a taxable account, thereby allowing the appreciation to be taxed (when you sell the stock) at long-term capital gains tax rates rather than ordinary income tax rates. (Note that your basis in the employer stock will still be taxed at ordinary income tax rates when you take it out of the 401(k))

Lump-Sum Distribution

A lump-sum distribution is the distribution or payment, within a single tax year, of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans). All of the participant's accounts under the particular plan must be distributed in order to be a lump-sum distribution. Additionally, a lump-sum distribution is a distribution that was paid:

  • Because of the plan participant's death,
  • After the participant reaches age 59½,
  • Because the participant, if an employee, separates from service, or
  • After the participant, if a self-employed individual, becomes totally and permanently disabled.

If you decide to take a lump-sum distribution, you need to be aware of the rules applicable to lump-sum distributions.  If they're not followed closely, you can end up paying a lot of unexpected taxes.

You need to be very specific as to who receives the distribution and when the lump-sum was received.  As long as the 401(k) account proceeds are distributed to some company (new employer, brokerage firm, etc.) within 60 days from the date you receive them, you're okay.  Otherwise you'll be paying a mandatory income tax withholding of 20%, even if you intend to roll the lump-sum over later.  If you later decide to to roll the funds over, you must roll over the original amount, meaning that you'll need to make up the 20% that was withheld for taxes.

Why Rollover to an IRA

If you like your employer's 401(k) plan and your employer allows you to keep it when you retire, then you probably should.  The administrative fees that you are charged for management of your 401(k) are roughly half of what you'll pay for an IRA, particularly if you worked for a Fortune 500 employer.  According to Morningstar, the average expense ratio of retail funds outside of an employer's plan is 1.3%.  This means that the money left with your employer could grow faster and last longer.

However, there are a number of reasons why you may want to consider rolling over your 401(k) to an IRA:

  1. An IRA can be obtained from many competing financial service companies, enabling you to shop for the best deal,
  1. The IRA may provide more and unique investment choices that your employer account doesn't (e.g., target date funds, hedged funds, managed futures, commodities, etc.),
  1. You will probably receive more personal attention, and possibly better professional management of your investment, particularly if you have a balance over $250,000,
  1. A rollover could allow you to consolidate all of your pre-tax plans into a single IRA, simplifying tracking and payouts, and
  1. Your IRA could enable you to qualify for relationship banking perks, such as free checking, discounted loans, etc.

You should consult your employer’s 401(k) plan prospectus and the current tax code for further information.

Penalty-Free Early 401(k) Distributions

The IRS allows for penalty-free withdrawals if the withdrawal purpose qualifies as a hardship, defined as “an immediate and heavy financial need.” Hardships may include medical bills, college-related expenses, money to avoid foreclosure or eviction, funeral expenses, and costs to repair damage to your home. A hardship withdrawal is limited to the amount needed to meet that need.

You will need to check with your employer plan provider to see if they allow hardship distributions (usually detailed in the summary plan description) and what the criteria might be.

Additionally, a provision in the Secure 2.0 Act allows for special emergency distributions of up to $1,000 per year. You can withdraw the money penalty-free and repay it over three years. Within those three years, no other emergency distributions can be taken out of the account unless the amount has been repaid.