Planning for your golden years can seem complicated, especially with all the rules and restrictions around retirement accounts. Saving in a 401(k) plan is certainly beneficial, as you can qualify for tax breaks and employer contributions. But you’ll also need to understand the rules involved when it comes to accessing those funds — especially early-withdrawal penalties.
“Always take the time to understand what you are doing with your money and the potential money moves that can help you amplify your wealth. Getting to know and understand your employer-sponsored retirement plan can be a game-changer,” says Alissa Krasner Maizes, founder of Amplify My Wealth.
It’s especially important to understand that 401(k) fees and penalties are associated with failing to withdraw the minimum amount at the required age or transferring your money improperly.
Here’s how to bypass common 401(k) fees and penalties:
1. Avoid the 401(k) early withdrawal penalty.
2. Shop around for low-cost funds.
3. Read your 401(k) fee disclosure statement.
4. Don’t leave a job before you vest in the 401(k) plan.
5. Directly roll over your 401(k) to a new account.
6. Compare 401(k) loans to other borrowing options.
7. Remember required minimum distributions.
8. Ask for better investment options.
9. Find a fiduciary.
1. 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 paying a 24% tax rate, 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.
According to Andrew Herron, certified financial planner and managing partner at Stone Pine Financial Partners, “401(k)s allow for some hardship withdrawals typically for disability and paying for unreimbursed medical expenses.”
If you don’t meet the requirements for an early, penalty-free 401(k) withdrawal, an IRA might have more flexible restrictions, Herron says.
“An IRA, as opposed to a 401(k), has additional qualifying circumstances that allow for penalty-free withdrawals. The big one is education expenses. If you need to dip into a retirement account to pay for education expenses (for you or someone else), see if you can roll over any 401(k) funds into an IRA first,” he says.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
2. 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.
3. 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.
4. 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’re 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.
5. 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.
[Read: How to Rollover Your 401(k).]
6. Compare 401(k) Loans to Other Borrowing Options
“Given the sharp rise in interest rates over the course of the last year, a loan from your 401(k) can look pretty attractive in certain circumstances compared to other traditional loans,” Herron says.
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 for which you might be eligible.
[Read: Best Low-Interest Personal Loans]
7. Remember Required Minimum Distributions
It’s important to note that 401(k) withdrawals are required after age 72 (or 73 if you reach age 72 after Dec. 31, 2022), 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 paying a 24% tax rate, skipping a $5,000 401(k) distribution would trigger $3,700 in taxes and penalties.
Note that required minimum distributions are undergoing some changes, thanks to the Secure 2.0 Act.
“Minimum required distributions, or RMDs, are required for Roth 401(k) accounts until the beginning of 2024, when the Secure 2.0 Act makes these accounts exempt from the requirement and eliminates the IRS penalty for not taking RMDs,” says Ohan Kayikchyan, CFP and founder of Ohan the Money Doctor.
8. 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 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.
[READ: What to Know About Withdrawing Money From a Traditional IRA.]
9. 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 fiduciaries, 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.
“Indeed, contributing to your employer-sponsored retirement plan rather than not is a great way to save for your long-term goals, but having a fiduciary financial advisor that puts your needs before their own can help ensure you reach your value-driven short- and long-term goals so you can live the life you want, increasing your likelihood of financial success and confidence rather than regrets,” Maizes says.
Working with a fee-only financial planner can help give you confidence that you are making appropriate investment decisions to build wealth for retirement.
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9 Ways to Avoid 401(k) Fees and Penalties originally appeared on usnews.com
Update 08/15/23: This story was previously published at an earlier date and has been updated with new information.
