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. Here's how to avoid some common 401(k) fees and taxes.
Avoid early withdrawals.
If you withdraw money from your 401(k) account before age 59 1/2, you will need to pay a 10 percent early withdrawal penalty, in addition to income tax, on the distribution. For someone in the 25 percent tax bracket, a $5,000 early 401(k) withdrawal will cost $1,750 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 percent 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 percent, 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. 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 percent will be withheld for income tax. If you don't put the entire amount, including the withheld 20 percent, 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. Loans that are not paid back within five years or upon 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 70 1/2, 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 percent of the amount that should have been withdrawn in addition to the regular income tax you owe on the distribution. For someone in the 25 percent tax bracket, skipping a $5,000 401(k) distribution would trigger $3,750 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 percent, 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.
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 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.