6 things to know before you start a 401(k)

When starting a new job, employees are usually told about the company's 401(k) plan. A 401(k) offers a great opportunity to start saving for the future.
Here are six things you should know before starting a 401(k), according to Clark:

1. HOW IT WORKSIt is set up by your employers and usually administered on their behalf by a big investment house like Fidelity.

You contribute a percent of your salary before taxes, which lowers your taxable income in the present.
The money comes out of your paycheck and goes directly into your 401(k) account.
You don’t pay taxes on the money you save until you withdraw it down the road in retirement. So you're lowering your taxes today and building up a nest egg, but that money will get taxed in the future.
Money expert Clark Howard likes the Roth 401(k), which allows you to contribute post-tax money that’s never taxed again. More on that here.

2. ANNUAL LIMITS

In November, the IRS announced that employees in 401(k) plans would be able to contribute up to $19,500 in 2020.
If you’re over 50, you’re allowed to make “catch up” contributions of an additional $6,000.
As a general rule, Clark advises people to bump up their contribution rate by 1% every six months. If you keep doing this year after year, you’ll eventually reach the annual max.

3. EMPLOYER MATCH

Many companies offer some kind of employer match on your 401(k). For every dollar you contribute, the employer will generally put in a percentage, up to a certain contribution level.

4. INVESTMENT CHOICES

Clark Howard advises people to invest money in target date funds. All target date funds are identified with a specific year in their name. Pick the year closest to when you expect to retire, and put your money into that fund. That invests your money in a simple portfolio that’s typically made up of stocks and bonds in a specific ratio that changes as you age.

5. WHY YOU SHOULDN'T BORROW AGAINST OR CASH OUT YOUR 401(K)

One surefire way to sabotage the hard work you’re doing saving for retirement is to borrow against your 401(k). Or cash it out entirely when you change jobs.
You’re likely to reduce or stop your contributions if you borrow against your 401(k) and are trying to pay it back. Your money misses out on future growth opportunities if it's not in the stock market.
If you choose to cash out your 401(k) before you reach 59 1/2, you’ll typically get hit with taxes and penalties that can eat up some 40% of your money.
According to Fidelity, the taxes and penalties you’ll face include, a standard 10% penalty for early withdrawal, state income tax and federal tax.

Some smarter alternatives include leaving the balance with your old employer’s plan if it’s being handled by a low-cost 401(k) provider. Roll the balance over to your new employer’s plan by doing a trustee-to-trustee transfer. More on these alternatives here.

6. REQUIRED MINIMUM DISTRIBUTIONS

Under IRS rules, you can begin withdrawing money from your 401(k) at age 59 1/2, if you wish. But by 70 1/2, you absolutely have to take money out each year, this is called required minimum distribution (RMD) rules.
If you don’t take your RMD annually once you reach 70 1/2, you face a tax penalty — regardless of whether you need the money or not.
More information on this topic:
Clark
IRS