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UNLOCKING THE FULL POTENTIAL OF YOUR 401K
Getting Started With Your 401k
For many, your 401k may end up being your largest financial asset and a key part of your retirement.
Whether you're just starting out, and contributing to a 401k for the first time or if you have been investing in one for a while, I think you will find value in the information provided here on this page.
With new rules and changes to 401k plans happening all the time, like the Secure Act and the Secure Act 2.0, my goal in creating this page is help you stay on top of the latest tips and strategies that can help you get the most out of your 401k.
- Bill Lethemon
Here's a Quick Recap of What You Will Find on This Page
Use the Hyperlinks to Jump Right to Whatever Section Interests You Most
Benefits of Starting Early: The Power of Early Investment in Your 401k
When it comes to planning for your retirement, starting to save and invest early in something like your 401k can have a huge impact on your long term results.
Consider This Scenario…
Meet Steve and James, both 30 years old and successful in their careers.
Steve decides to start investing in his 401k plan right after his 30th birthday, contributing $10,000 per year.
On the other hand, James feels he has too many expenses and prefers to enjoy some “fun stuff” instead of investing in his 401k. He delays his contributions for 10 years. It’s only after his 40th birthday, inspired by Steve’s success, that James starts contributing $10,000 per year to his 401k.
Who Ends Up with More Money?
Assuming they both earn an average annual return of 7%, and check their account balances on their 65th Birthday here’s how it looks…
- Steve’s 401k balance grew to $1,382,368
- James’s 401k balance, however, grows to just $632,490.
That’s a staggering difference of $749,878! Over twice as much!
Even if James were to double his contributions to $20,000 per year, his account would grow to $1,264,980—still short by $117,388. Furthermore, James would have contributed a total of $500,000 compared to Steve’s $350,000.
Add in a company match, and these numbers would have heavily favored Steve’s strategy to start early even more!
The moral of the story…Start saving as early as you can!
Consider just one more thing. If Steve started saving the $10,000 per year after his 25th birthday, assuming the same 7% growth rate his account would grow to $1,996,351.
The $50,000 Steve contributed in his 20’s (from 25 to 29) added $613,983.
The Power of Compound Interest!
How Does a 401k work?
401k plans are retirement savings accounts offered through employers that can help you save money for your retirement. They are super convenient because your contributions are deducted right from your paycheck before you even get a chance to spend it.
There are also tax advantages and depending on your employer, you may also be eligible for a matching contribution. (free money!)
Pay Taxes Now or Pay Taxes Later (The 4 Types of 401k Contributions)
1.
Traditional 401k (Save money in taxes now, Pay taxes later)
If you choose to have the money go into your 401k before taxes, you are investing in the Traditional 401k and the amount you contribute is not included in your taxable income for the year.
The taxes you will owe on this, plus any growth you may experience is deferred until the time that you make a withdrawal. Ideally after age 59 1/12 to avoid penalty. (more on this later on the page)
2.
Roth 401k (Pay taxes now, save money in taxes later)
With the Roth 401k, there is no immediate tax benefit at the time you make your contributions. The amount you contribute will be included in your taxable income for the year, the same way it would have if you elected to receive the money in your paycheck. The benefit of the Roth is that all of your withdrawals as long as they’re qualified are 100% tax free. This includes not only your original contribution, but the growth as well.
***In both the Traditional and the Roth, Distributions before age 59 1/2 may be subject to a 10% premature withdrawal penalty in addition to any taxes you may owe.
3.
Employer 401k Matching Contributions (Free Money)
Many 401k plans have a feature where your employer will make a matching contribution to your 401k plan on your behalf. This is literally free money, so you don’t want to miss out! My recommendation generally would be to contribute at least enough to maximize the amount of match you can get from your employer.
Think of match like a bonus or additional compensation. But if you don’t contribute you won’t get it!
How 401k Matching Works (2 Types of 401k Match)
Full Match means that you will receive a match for 100% of the amount you contribute, usually up to a certain percentage of your salary.
Full Match Example; Betty works for ABC Company and has a 100% 401k match up to the first 6% of her base salary. If Betty’s base salary is $100,000 per year and Betty contributeds at least $6,000 or 6% of her salary, ABC would match her dollar for dollar up ot $6,000 or 6% of her salary.
Partial Match means that your match would be a percentage of the amount you contribute, usually up to a certain percentage of your salary
Partial Match Example; Nolan works for XYZ company and has a 50% match up to the first 8% of his base salary. If Nolan’s base salary is $100,000 per year, XYZ would match up to $4,000 as long as he contributes at least $8,000 to the 401k.
401k Vesting (How it works)
Vesting is a way for employers to retain employees by requiring them to stay with the company for some minimum amount of time before the matching contributions are yours to keep. But don’t worry, your contributions are always 100% vested from day 1 and there is never a vesting period for money you put in.
401k Vesting 2 Examples
- All 401k matching contributions vest at the end of a 3 year initial vesting period. So if you were to leave the company anytime during the first 3 years of employment you would lose all of the money your employer contributed on your behalf, including any growth that may have occured as well.
- 5 year vesting schedule where each year 20% of your matching account vests and is yours to keep even if you leave the company. So, if you left after 2 years 40% of your account would be vested and yours to keep. After 5 years all matching contributions would be vested.
401k Matching Contributions now eligible to direct to Roth
With the passing of the Secure Act 2.0 in late 2022 Employer Matching Contributions are now eligible to be directed to your Roth 401k (It’s only optional, your plan may not allow this feature). Prior to Secure Act 2.0, all matching contributions were directed to your pre-tax Traditional 401k Account.
If you elect the Roth 401k option, the amount of the match would be added to your taxable income and reported on a 1099R that you will receive at tax time.
*** Taxes are not typically withheld from your paycheck for this taxable income, so you will want to make an adjustment to your payroll tax withholding or make estimated quarterly tax payments, so you don’t get blindsided with a big tax bill or worse a penalty when you file your taxes.
4.
After Tax 401k Contributions
According to the Plan Sponsor Council of America, Roughly 21% of company plans offered after-tax 401(k) contributions in 2021. If you work for a large company and/or have one of the larger 401k providers such as Fidelity or Vanguard you may have a better chance of having this option.
If available in your plan, the after-tax savings option could allow you to continue to save money in a tax deferred savings account even after you’ve hit the normal contribution limits for the standard Traditional or Roth 401k. (more on the contribution limits in the next section)
What Exactly is an After-Tax 401k Savings Option?
How an after-tax 401k savings option works
With after-tax savings contributions money is contributed on an after-tax basis and grows tax deferred. Note that this is different than the Traditional 401k which is contributed pre-tax and grows tax deferred or the Roth which is contributed after-tax but grows tax free.
Why would you want to contribute to an after-tax 401k account in your employer sponsored retirement plan?
First, this really only makes sense after you’ve already maxed out your annual contribution limit for your 401k, and at least considered a Roth IRA contribution. (if you qualify)
But, if you’re still looking, to save money for your retirement the after-tax savings account may be a good option.
While the after-tax savings account has been an option in many employer sponsored retirement plans for decades, it wasn’t until a 2014 IRS Tax Notice, that really made this interesting.
IRS Tax Notice 2014-54, provided clarification that these after-tax saving accounts could be converted to a Roth IRA. So in effect, it’s become a way, to get more money in a Roth IRA, even if you’ve already maxed out your 401k, and even if you make too much money to contribute to a Roth IRA directly.
Here’s an example; (I’ll get into the limits in the next section)
Mary is already maxing out her annual contribution limit for her 401k plan including the catch up provisions, since she’s over 50, but she still would like to save additional money for her retirement.
She could open a normal taxable brokerage account, but then she would be subject to annual taxes on her capital gains, dividends and interest.
Instead she decides to contribute $10,000 to her employer after-tax account with ongoing deductions from her monthly paycheck. As her after-tax account grows she can periodically, as the plan allows, convert those assets to a Roth IRA or if the plan allows, an in-plan Roth Conversion. I’ve even seen some 401k plans that will do this for you automatically.
This after-tax to Roth strategy is often referred as the Mega Back-door Roth Strategy
Mapping Your 401k Contribution Strategy: How Much Can You Save in Your 401k?
The 2024 401k Contribution Limits
2024 401k Contribution Limit
For 2024 the maximum annual employee contribution is $23,000. The amount can be contributed to either Traditional or Roth or split between the two. There are no income restrictions for contributing to either one.
401k Catch Up Contributions
For individuals aged 50 and older, you are allowed an extra “catch up” contribution. For 2024 the catch up contribution is $7,500
If you’re 50 or older you can contribute a total of up to $30,500 to your 401k
Increased 401k Catch Up Contributions for individuals aged 60 to 63 (2025)
The Secure Act 2.0 created an enhanced catch up provision for individuals aged 60 to 63, this will go into effect in 2025,
During just those 4 years, the catch up contribution will increase to the greater of $10,000 or 50% more than the regular catch up amount.
After 2025, the catch up contributions will be indexed annually for inflation.
401k Matching Contributions High Earners
The Secure Act 2.0 also added in a rule that high income earners, defined as those making $145,000 or more per year, would be required to direct all of their catch up contributions to the Roth Account. This was originally intended to go into effect in 2024, but IRS Notice 2023-62 provided guidance that delayed this rule by two years. Now scheduled to go into effect for tax year 2026.
- Coincidently, or not, this is the same year the Tax Cuts and Jobs Act Rates will be expired.
Adding it all up, The Maximum Amount that can go into your 401k
As mentioned earlier on this page, your 401k contributions can consist of;
- Regular 401k Contributions (Roth or Traditional)
- Employer Matching Contributions
- After-Tax Contributions
For 2024 the total for all contributions to an employer sponsored retirement plan is $66,000 per year. If you’re 50 years old or older, with the catch up contribution of $7,500, you would be eligible to contribute up to $73,500.
As mentioned earlier, not all 401k plans will have a match or the option to contribute to an after-tax account. Even if you do have an after-tax option, your employer could still limit the amount that you can contribute, even if you still have room within the IRS limits
How Much Should you Save in your 401k?
Just because you can save this much money in your 401k, that doesn’t necessarily mean that you should save this much money in your 401k.
I know this may go against what many financial advisors and guru’s may tell you, but I believe in balance.
How much to contribute to your 401k or save for your retirement is always a trade off, between having “fun” with the money today vs saving it for your future.
Having a clearly defined plan so you know why you’re saving the money and what that’s going to do for you in the future is important to maintaining this balance.
I’ve seen too many cases where someone was way too focused on saving and investing, and, in almost an unhealthy way, addicted to watching the numbers on their statements. They sacrificed too much and bypassed a lot of things they could have done along the way, like taking vacations with family. Always saying that they will do it when they retire. Some people may not live to enjoy their retirement and others may find the things they wanted to do aren’t as enjoyable or even possible due to health issues.
The point is, money should be viewed as a tool for what it can do for you, and how it could potentially enhance your life. By no means does this mean that you shouldn’t save money for your future, but you want to have a clear vision on what the appropriate balance is for you, between saving money and enjoy things today.
Having a detailed long term plan can help you do that. You can check out ours here.
How to Get Your Money Out of Your 401k
Typically money contributed to your 401k is intended to be invested until you’re at least 59 1/2 to avoid penalties. In this section I’m going to address ways you could get access to your 401k while you’re still working or after you retire or separate service from your company and how you could avoid penalties.
Getting Money Out of your 401k While You're Still Working
How 401k In-Service Withdrawals Work
Some 401k plans have a feature that could allow you to rollover a part of your 401k or even your entire 401k to an IRA while you’re still working and actively contributing to the plan.
**** Remember, you have 4 options with your 401k before you rollover any money.**
- Keep your 401k with your plan
- Rollover your 401k to a new employer plan (if allowed)
- Roll it over to an IRA Account
- Cash it out. (Taxes and potentially an early withdrawal Penalty may apply)
Rolling over your 401k may provide additional investment options, ability to work with a financial advisor and consolidate financial assets. However, there may disadvantages of doing a rollover as well including loss of some tax and withdrawal benefits.
** For more on pros and cons of doing a 401k Rollover see below.
What can I rollover as an In-Service Withdrawal?
While all plans have a different set of rules some plans here are some common sources for an In-Service withdrawal. Check with your plan administrator to see what your plan allows.
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Company Match. As long as it’s vested, many 401k plans allow for a rollover of company match contributions.
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Age 59 1/2. For most 401k plans that we see, it is common for you to have the ability to rollover your entire 401k plan to an IRA after reaching the age of at least 59 1/2. Even if you’re still an active participant.
-
After-Tax Savings. With after-tax savings you basically have two choices.
- You can cash out the contributions and take it out of your plan to use however you want with no taxation. The money was contributed to the account after taxes, so the taxes have already been paid. If your plan allows you can tap into this source at any age.
- The second choice is to use the after-tax account to fund your Roth IRA as a Mega-Back Door Roth Strategy. You would simply do an after-tax to Roth Conversion.
*** 401k plans have different rules on how your after-tax account can potentially be separated between the portion you contributed that has already been taxed and any growth that may have occurred that has not yet been taxed. Make sure you check with your plan and understand how this is treated before doing any rollovers or withdrawals of after tax funds.*
How a 401k Loan Works
401k Plans generally have a loan provision that allows you to “borrow” funds from your 401k Account.
How much you can borrow from your 401k is typically limited to 50% of your current account balance or $50,000 whichever is lower.
An interest rate is set by the rules of your plan and is typically the Prime Rate plus 1 or 2 percent. As of June 2024 the Prime Rate is 8.5%. So your rate could be 9.5% to 10.5% or more.
Principal and interest are paid back to your 401k plan through regular payroll deductions with a loan term of 5 or 10 years. If its housing related, the term can usually be 10 years, but if its for anything else, it would usually be 5 years.
When the loan is established the money is removed from whatever investments you had and the money them becomes “invested” in your loan.
While it is true that you’re paying the interest back to your own account, some may think that the loan is technically free. However, because the loan amount is taken from your investments, you really are losing out on the potential return of whatever those investments would have earned.
What Happens to your 401k Loan when you retire or leave the company?
When you retire or change jobs with an outstanding loan you may be required to pay back the loan in full within a short window of 30 days or less.
If you fail to repay the loan within the allowed time, the outstanding balance of the loan will be treated as a distribution and subject to taxes and, if you’re under 59 1/2 a 10% premature penalty as well.
How a 401k Hardship works
According to the IRS a hardship distribution from your 401k, is a withdrawal for an “immediate and heavy financial need”, and is limited to the amount necessary to satisfy that financial need.
An immediate and heavy financial need could be defined as an unexpected disability and/or extreme medical bills. Probably not something like money to replace your broken dishwasher.
The money taken from your 401k as a hardship withdrawal is not required to be repaid, however you are required to pay taxes on the amount distributed. If you’re under 59 1/2 you would not be assessed the normal 10% penalty for early withdrawals.
Getting Money out of your 401k When you Retire or Separate Service
When you retire or separate service and have a 401k plan with your employer you have some options. Understanding your options before you do a rollover, can potentially save you from making a costly mistake.
As mentioned earlier on the page you have 4 basic options for what to do with a 401k when you retire or change jobs.
- Keep your 401k with your plan
- Rollover your 401k to a new employer plan (if allowed)
- Roll it over to an IRA Account
- Cash it out. (Taxes and potentially an early withdrawal Penalty may apply)
401k Rollover Pros (why you should rollover your 401k)
- Access to more or different investment options
- You want to work with a financial advisor on your investment strategy
- Lower fees (potentially, see How much does your 401k really cost below)
- Consolidation of your financial assets
- Access to a special tax treatment (see below)
401k Rollover Cons (why you shouldn’t rollover your 401k)
- You like your plan and the investment options and fees
- You separated from the company in the year you turned 55 or later, but are not yet 59 1/2/ (see age 55 rule below)
- You want to do a back door Roth IRA Contribution Strategy. (the back door Roth contribution strategy only makes sense if you don’t have any other IRA accounts. If you rollover your 401k to an IRA, the new IRA would dramatically complicate your ability to use this strategy)
401k Special Tax Treatment of Company Stock (Net Unrealized Appreciation or NUA)
If you own employer stock inside your 401k plan, you may qualify for a special tax option called Net Unrealized Appreciation or NUA. This special tax treatment is only for stock in the company you work for.
Here’s how Net Unrealized Apreciation (NUA) works
The 401k NUA rules allow you to distribute company stock from your 401k to a regular non-retirement brokerage account. (not an IRA).
At the time of the distribution you would pay taxes at your ordinary tax rate on just the cost basis of the stock, not the entire distribution.
The gain then gets classified as Net Unrealized Appreciation and taxes would be paid at the time the stock is sold at your long term capital gains tax bracket. There is no need to wait 12 months as you normally would for the long term capital gains tax treatment. You could sell the stock immediately.
Any growth that occurs from the time the stock is distributed to the time the stock is sold would be taxed at the short term capital gains tax rate if its been less than 12 months since the stock was distributed. If held for 12 months or longer it would qualify for the long term capital gains tax rate.
Net Unrealized Appreciation (NUA) Example
Cynthia is a Marketing Executive for Coca Cola and has $150,000 of company stock in her 401k plan. She is over 59 1/2 and currently in the 24% tax bracket with $75,000 of room before she goes into the next bracket. After calling her 401k provider, she learns that her cost basis on the shares is just $50,000.
After discussing with her advisors, she decides to distribute her stock from the 401k, using NUA treatment to her non-retirement brokerage account, and in doing so pays taxes at her ordinary tax rate of 24% on the $50,000 cost basis. The $400,000 of gain in the stock is not taxed at the time of the distribution, but is classified as Net Unrealized Appreciation.
A Month after distributing the stock, the stock is now worth $160,000, and she decides to sell it all. Here’s how it breaks down…
| Here’s how the taxes on her NUA Stock work | |
|---|---|
| Tax on the $50,000 cost basis paid at her ordinary income tax rate of 24% | $12,000 |
| Tax on the Net Unrealized Appreciation $100,000 (due to sale of stock) Taxed at the long term capital gains rate 15% | $15,000 |
| Tax on $10,000 gain from the time stock was distributed. Taxed at the short term capital gains tax rate 24% (less than 12 months, her ordinary tax rate) | $2,400 |
| Total Tax | $29,400 |
If Cynthia instead kept the stock in her 401k and sold it then
| Here’s how the taxes would have worked if she sold the stock in her 401k and distributed the proceeds ($160,000) | |
|---|---|
| $75,000 Taxed at the 24% bracket (amtount remaining before 32% bracket) | $18,000 |
| $85,000 taxed at the 32% ($160,000 minus $75,000) | $27,200 |
| Total Tax | $45,200 |
Using NUA Cynthia saves $15,800 in taxes!
Net Unrealized Appreciation is not for everyone. It needs to be considered within a complete long term financial plan. Understanding not only how it may impact your plan and your taxes now in the short term but also the long term impact as well.
What Is the Age 55 Rule And How Does It Work?
Did you know that you may not have to wait until turning 59 1/2 to access the money in your 401k without paying a penalty?
That’s right! If you separate service from your company in the year you are turning 55 or later, you can take withdrawals from your 401k without paying a penalty. Even if you’re still not 59 1/2.
This rule only applies to your 401k not an IRA. So if you rollover your 401k to an IRA you are not going to be able to use this option.
How Much Does your 401k Really Cost?
Contrary to what many people believe, your 401k plan is not free! While it is true that your company is probably paying some administrative costs for setting up and maintaining the plan, you, the participant are paying for all of the investment costs associate with the individual investments you select.
401k fee’s can vary wildly from one plan to the next and according to BrightScope/ICIData as of March 21, 2024, the average fees for a 401k plan with $1 billion or more in assets was just .27%, while smaller plans with less than $1 million in assets had an average fee of 1.27%.
That’s 5 times the average cost for a 401k plan if you work for a small company vs. working for a larger company!
How to Invest Your 401k
I’m not going to get too far into the weeds here on this page when it comes to choosing investments for your 401k. Everyone is going to be different when it comes to different types of investments and how comfortable you are with risk.
Generally speaking though, if you’re a younger investor with more time to retirement, you can afford to take on more risk with your portfolio, because you have time to “ride out” market downturns.
If you’re closer to retirement, you really want to be thinking about how, when and how much you may need to withdrawal from your retirement portfolio and have a strategy for dealing with that. My opinion, is if you will be needing to begin withdrawals within the next 5 years, you should consider shifting towards a more conservative portfolio.
Dollar Cost Averaging
With a 401k plan you will likely be adding money to your account on a regular basis, most likely with every paycheck.
As money is contributed and invested to your account over time, sometimes the market will be higher and sometimes the market will be lower. By continuously adding money to your account it tends to have a smoothing effect on market volatility by sometimes buying high and sometimes buying low.
Important to note, that dollar cost averaging does not eliminate risk!
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Investing your 401k: 3 Categories of Investment
Your 401k plan may have 3 broad categories of investments you can choose from. Not all 401k plans have these, but this is what we see most often
1.
The Core 401k Menu
2.
Target Date Funds
Because building a portfolio from the core menu can be more complicated for some investors, many 401k plans have added in “Target Date Funds” as an easier alternative. In fact, many plans use the Target Date fund as the default investment option for plan participants.
Here’s how a Target Date Fund Works
With a Target Date fund you select a year that most closely matches with the approximate year of your retirement.
For example; If you’re 35 years old and plan to work to age 65, you will be 65 in 30 years. If its now 2024 that puts your retirement in the year 2054. The plan probably doesn’t have a Target Date Fund for 2054, But they may have one for 2055. You just want to pick a Target Date Fund that gets you close to the year you’re planning to retire.
A Target Date Fund will slowly shift the risk level of your portfolio towards a more conservative asset allocation as you get closer to your retirement date. Every Target Date Fund has a different “glide path” and some may be more aggressive than others even if they have the same target year.
2022 was a Rough Year for Target Date Funds!
According to data from Morningstar Direct, in 2022, the median return for U.S. Based 2025 Target Date Funds was -15.4%. (2025 Target Date Funds are for those individuals closest to retirement!)
Target Date Funds do not “mature” and are not guaranteed in any way shape or form.
3.
The 401k Self Direct Brokerage Account
What is the 401k Self Direct Brokerage Account?
Basically it’s an account within your 401k plan where you can partition off a portion of your assets, or, if allowed even 100%, into a special account that acts a little more like a regular investment account.
While not all 401k plans have this, according to CNBC, in 2023 approximately 40% of 401k plans offered a Self Directed Brokerage Account or Self Directed Brokerage Window.
The potential benefit of the Self Directed Brokerage Account is that it can give you access to investments that are not part of the core investment menu. Depending on what your plan allows, you may be able to buy Individual Stocks, Mutual Funds or Exchange Traded Funds in your Self Directed Brokerage Account.
These additional options can really open things up for more sophisticated investors that want to get more involved in managing their 401k investments.
Using the self directed brokerage account is not for everybody and may riskier than sticking to Target Date Funds and the Core Menu.
There will also likely be additional fees associated with the Self Directed Brokerage 401k such as commissions every time you buy or sell a security. Mutual Funds and ETF’s that you purchase will also have fees. Make sure you fully understand all of the costs before you buy.
