How much do you know about your 401(k)? Probably not a lot. If you're like most people, you choose a contribution level and review your balance when the statement arrives. But that could be dangerous. If you don't understand the policies of your plan, you just might stumble into traps that could seriously devalue your retirement stash. Before you fall prey to a costly mistake, read on.
1. You Might Never Get That Match
You might think your company match is making you rich. But you may be surprised to learn that with some companies, if you leave your firm before three years is up, you won't get a penny of it. You see, employers have some leeway as to when you can receive your match. These days, the longest they can make you wait is three years. (Back in 2001 the maximum was five years, so this is a big improvement.) Unfortunately, a three-year vesting period, known as a "three-year cliff," means many employees will have moved on to other jobs at different companies before they're eligible for their match.
The good news, however, is that over the past few years, an increasing number of companies have been going the other way, by offering immediate vesting — which means that match is yours from day one. Back in 2001, 33% of large companies offered this type of match. Now 38% of them do, according to the 2003 Trends and Experience in 401(k) Plans survey by benefits consultant Hewitt Associates.
So, what can you do if your company makes you wait? Grass-roots action. See our article "7 Ways to Lobby for a Better 401(k)" for ideas on how you can work to change your company's plan. You only other option is to hang around for a while. Our calculator will tell you whether it's worth the wait.
2. If you take a loan then leave the company, you'll have to pay the loan back — pronto.
Sure it's nice to know that you can always borrow from your 401(k). But be warned: If you quit, are laid off, or fired, you're probably going to have to pay that loan back immediately. "You might be obligating yourself to pay back that loan at one of life's worst times," says David Wray, president of the Profit Sharing/401(k) Council.
What happens if you can't repay the loan? It will be treated as an early withdrawal. That means you'll owe taxes plus a 10% penalty. Bottom line? Think long and hard before borrowing. Your own 401(k) account could turn out to be the harshest collector you've ever encountered.
3. If your account is less than $5,000 when you leave the company, you could get cashed out.
If your account holds less than $5,000, then be prepared to roll over your money when you leave your company. Otherwise, your company could cash you out. (If your account is more than $5,000, relax. Your former employer must let you keep your money where it is — if that's what you really want to do.)
Now, being cashed out is not necessarily a big deal. But you'll save yourself a big headache if you tell your employer where you want your 401(k) assets to go when they're rolled over. That way the employer can make out the check to your IRA trustee (broker or mutual fund company) or your new employer's 401(k) plan. Otherwise, your former company will make out the check to you. In that case, the firm will withhold 20% for taxes. You'd get that money back when you file your tax return next year. But meanwhile, you've got to replace it, otherwise you'll face income taxes and a 10% early withdrawal penalty.
Being prepared will also help you meet the 60-day requirement for rolling over your 401(k). What happens if you don't reinvest the money within 60 days? In most cases, your account will be treated as an early withdrawal, which means — you guessed it — taxes plus a 10% early withdrawal penalty. (A few exceptions apply, including if the financial institution handling the distribution has made some sort of error, or if you are in the hospital.) And there's no going back. After 60 days that money is yours, you cannot reinvest it in a rollover IRA or a new 401(k).
4. You may be charged a load to buy your mutual funds.
If you work for a small company, you may be paying sales charges to buy the mutual funds in your 401(k) plan. This is unacceptable. These fees often shave 4% off everything you invest. Or you could be paying 12b-1 fees that take as much as a percentage point out of your returns each year. Add to that some of the other fees that employers pass along to their employees — such as investment transaction fees and even record keeping fees — and suddenly that company match becomes less attractive.
What should you do if you are paying sales charges? Lobby your employer to switch to a no-load 401(k) provider like Fidelity Investments or Vanguard Group.
5. You may be stuck buying tax-advantaged investments in a tax-deferred plan.
Talk about a belt and suspenders. There are actually plenty of plans out there, especially 403(b) retirement plans for nonprofit organizations and schools, that offer tax-advantaged investments, like variable annuities. This is pointless. Your retirement plan is already tax-deferred. There is no point settling for the lower returns and higher costs of a variable annuity to get tax-deferral there as well.
"It's unfortunately too common in 403(b)s," says Ted Benna, president of the 401(k) Association. "Some small employers make investment decisions based on a relationship with an insurance provider or someone else's recommendation."
So what can you do? Ask your plan administrator if you can transfer (tax-free) part or all of your account into a 403(b)7 account. These accounts are invested directly in mutual funds, without the insurance wrapper, says Janet Anderson, an associate at benefits consultant William Mercer. But you need to proceed with caution. First of all, make sure you do a trustee-to-trustee transfer (otherwise you risk the early withdrawal penalty). And if your annuities are subject to surrender fees, for example, then the most you will be able to transfer penalty-free from your account is just 10% annually.