Saving in a 401(k) plan allows you to qualify for tax breaks and employer contributions. However, in order to keep that money, you need to steer clear of 401(k) penalties. There are penalties if you withdraw money from a 401(k) too soon or too late. Most 401(k) plans also charge a variety of fees that could require some effort to avoid. Here’s how to minimize some common 401(k) fees and taxes.
Avoid the 401(k) early withdrawal penalty.
If you withdraw money from your 401(k) account before age 59 1/2, you will need to pay a 10% early withdrawal penalty, in addition to income tax, on the distribution. For someone in the 24% tax bracket, a $5,000 early 401(k) withdrawal will cost $1,700 in taxes and penalties. There are a couple of exceptions to the 401(k) early withdrawal penalty. For example, if you lose or leave your job at age 55 or later, you won’t have to pay the 10% penalty on withdrawals from the 401(k) associated with the job you most recently left.
Shop around for low-cost funds.
If the expense ratio of any of the funds in your 401(k) is over 1%, you’re probably paying too much. A workplace 401(k) plan offers a limited menu of investment options. Often, some of the funds cost significantly less than others, even within the same investment class. Make sure to consider the cost of each fund when selecting investments for your 401(k) plan. Since retirement investments are generally held for a long period of time, keeping costs down is particularly important. Switching to a lower-cost fund will reduce your investment costs and help your 401(k) balance grow faster.
Read your 401(k) fee disclosure statement.
Your 401(k) plan is required to send you a fee disclosure statement each year. This document lists key pieces of information about every investment option in your 401(k) plan, including the annual gross expense ratio of each fund. The costs are listed as a percentage of the account balance and the dollar value of the fee for each $1,000 invested in the fund. The statement will also list additional fees associated with each fund or charges you might incur if you take specific actions. Your 401(k) fee disclosure statement allows you to quickly determine how much each fund costs to own and if there is a similar lower-cost fund available in the plan.
Don’t leave a job before you vest in the 401(k) plan.
While you always get to keep your personal contributions to a 401(k) plan, you can’t keep your employer’s contributions until you are vested in the 401(k) plan. While some companies provide immediate vesting for the 401(k) match, others require as long as two or three years of service before you are eligible to keep any of the match if you leave the firm. Some employers allow you to keep a percentage of the 401(k) match that depends on your years of service, but you might not get to keep all of it unless you stay with the company for five or six years.
Directly roll over your 401(k) to a new account.
When rolling your 401(k) balance over to an IRA or another 401(k), it’s important to transfer the money directly from your 401(k) to the custodian of the new account. If the check is made out to you, 20% will be withheld for income tax. If you don’t put the entire amount, including the withheld 20%, into a new retirement account within 60 days, any portion not rolled over is considered a distribution, and income tax and the early withdrawal penalty may apply.
Compare 401(k) loans to other borrowing options.
While typically less damaging than an early withdrawal, 401(k) loans charge a variety of fees. Most 401(k) loans have origination, maintenance and administration fees. Plus, if you leave your job, the loan becomes due sooner. Loans that are not paid back within five years or shortly after leaving your job can trigger income tax and the early withdrawal penalty. If you need to borrow money, compare the terms of the 401(k) loan to other types of loans you might be eligible for.
Remember required minimum distributions.
It’s important to note 401(k) withdrawals are required after age 72, unless you are still working for a company you don’t have an ownership stake in. The penalty for missing a required minimum distribution is 50% of the amount that should have been withdrawn in addition to the regular income tax you owe on the distribution. For someone in the 24% tax bracket, skipping a $5,000 401(k) distribution would trigger $3,700 in taxes and penalties.
Ask for better investment options.
Your 401(k) plan likely offers a small selection of investment options chosen by your employer or plan sponsor. If all the funds in your 401(k) plan charge fees higher than 1%, it could be worth contacting your human resources department and pointing out that there are much lower-cost funds available that would make a great addition to the 401(k) plan. Switching to a lower-cost 401(k) provider can save employees and the company money.
Find a fiduciary.
If you don’t feel comfortable selecting your own investments, you might want to seek professional help. However, it’s important to find out if your financial professional will boost his or her compensation by steering you into high-cost investments. Ask potential financial advisors if they are willing to act as a fiduciary, which means they will be required to recommend investments that are in your best interest, and not the funds that result in the biggest profit for the advisor. Working with a fee-only financial planner can help give you confidence that you are making appropriate investment decisions to build wealth for retirement.
Here’s how to avoid 401(k) fees and penalties:
— Avoid the 401(k) early withdrawal penalty.
— Shop around for low-cost funds.
— Read your 401(k) fee disclosure statement.
— Don’t leave a job before you vest in the 401(k) plan.
— Directly roll over your 401(k) to a new account.
— Compare 401(k) loans to other borrowing options.
— Remember required minimum distributions.
— Ask for better investment options.
— Find a fiduciary.
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9 Ways to Avoid the 401(k) Early Withdrawal Penalty and Other Fees originally appeared on usnews.com
Update 03/07/22: This story was published at an earlier date and has been updated with new information.