Creating Wealth - Get Rich Slowly (part 2)

Get your money right first

In case you missed last week's blog, there are a few steps you should take before moving your life's savings into a retirement account without a plan. Before you start building wealth, take a minute to get the basics in order:

• Pay off any high-interest debt.
• Build an emergency fund, so you're not scrambling at unexpected expenses.
• Do yourself a favor and build a budget.

What is a 401(k)?

A 401(k) is another common way to save for retirement. This method of investing is tied to your job. Similar to IRAs, there are traditional and Roth 401(k)s that tax you either when you put in the money (Roth) or when you withdraw funds (traditional). There are a few basics of a 401(k) that are important to know:

• You can take out loans against your 401(k).
• You have to start taking money out when you turn 72.
• Your HR department is a great resource for this if you have any more questions.

Getting Started

Unlike IRAs, you are unable to open a 401(k) on your own. The good news is, when you start a new job, HR should help you understand your benefits. A 401(k) is often included in those benefits, so you will sign up for a plan through your employer.

Many employers make it easy for you to easily contribute a percentage of your paycheck directly to your 401(k). This percentage will automatically be added to your 401(k) instead of your bank account. When you sign up, you will need to select from your employer's offerings of various stocks and bond mutual funds.

Contribution Match

Many employers offer some sort of match for 401(k) contributions. The way your employer matches will vary by company, but your HR department will be able to provide you with this information. If yours does, make sure to contribute as much as they will match. That's free money, folks!

Contribution Limits

The maximum amount an employee can contribute to a 401(k) as of 2020 is $19,500 per year unless you are over 50 years old. If you are over 50, you can contribute up to $26,000. The total contribution allowed for your contributions plus your employer match is capped at $57,000, or 100% of your compensation (whichever is lower). If you are over 50, this limit is $63,500.

Withdrawals

To access money in a Traditional or Roth 401(k), you must be at least 59 1/2. If you withdraw money before this age you will face a 10% penalty on top of any other taxes owed. There is currently an exception for individuals affected by COVID who need to access the money right now. In this case, you are allowed to withdraw up to $100,000 without the penalty and pay any taxes on these funds over 3 years. This is an unprecedented exception, so be sure to get an emergency fund started to avoid having to pay the penalty.

Required Minimum Distributions

Whether you have a Traditional IRA or a Roth IRA, you will be required to withdraw funds after you turn 72. The amount of these required minimum distributions (RMDs) depends on the amount of money in the account and your age. If you're still working at 72, and your account is with your current employer, you might not have to take RMDs from that plan.

Changing Your Job

So you get your dream job and are all ready to sign the offer, but what happens to your 401(k) with your old employer? Good news, you get to keep the money. You have a few options for what to do with all your hard earned money (and compound interest you didn't have to work nearly as hard for).

First, you could withdraw the money. The money will be taxable in the year it's withdrawn, and unless you are over 59 1/2, you will have to pay the 10% penalty on the withdrawal. Although this rule was suspended for 2020 because of the pandemic, this is generally not a great choice unless you absolutely need the money.

Second, you could roll the money over into an IRA. This keeps the account's tax-advantaged status and helps you avoid any withdrawal taxes. Make sure to work with whatever financial institution you are rolling this money into to prevent breaking any IRS rules on rollovers.

Third, you could leave the money with your old employer. Most employers let you leave a 401(k) account with your old plan until you retire, although you won't be able to make any further contributions to it. You will be able to open a new 401(k) with your new employer and contribute there instead). If you really liked your old plan, this could be a good option for you. Just make sure you don't forget about the account!

Fourth, you could move your 401(k) into your new employer's plan. Check with HR to make sure they allow this, but this is a great way to maintain the tax-deferred status. If you're close to 72, this is also a great option because the money won't be subject to RMDs.

Deciding which option to choose depends on your employer's offerings and personal comfort with each plan, but no matter what you choose your money is still yours!

Leaving Before You're Fully Vested

If you're wondering what vested even means, you're not alone. Being fully vested in a 401(k) means you can take 100% of the funds your employer contributed to your plan with you if you move on from the company. On the other hand, if you are 20% vested in your plan at the time you leave, you are only able to take 20% of the money your employer contributed to your 401(k). No matter what, you will never lose out on the money you contributed yourself.

Often, employers require you to stay at the company for a specific time period (i.e., 5 years) before being fully vested, or they will increase the amount you are vested in your plan each year by a certain percentage. These terms vary by employer, and your HR representative should be able to walk you through what happens if you leave before you are fully vested.

You will always be able to take whatever you contributed to your own account with you, but leaving before you are vested could cost you. Make sure you know your employer's policy because sometimes staying an extra few months means a much larger payoff.

Stay tuned for our next blog, where we'll talk about how you can set your kids up for a more secure financial future, helping to build generational wealth.