Portfolio Perspective

What you need to know about 401(k) plans

The bad things good people do with their 401(k) plans
The bad things good people do with their 401(k) plans

Many workers have access to a 401(k) retirement savings plan, but that doesn't mean they understand much about it.

Financial advisors routinely see new clients who either have little grasp on the inner workings of their 401(k) plan or have no idea why they picked the investments in their account that they did.

"A lot of times, no one really unpacks the operating manual for people to show how the vehicle works," said certified financial planner Stephanie Genkin, founder of My Financial Planner.

If you're part of the befuddled crowd, advisors say that taking time to understand some key aspects of these tax-deferred retirement plans can help you make smarter decisions for building your nest egg.

Jamie Grill | JGI | Getty Images

For starters, it's important to remember that a 401(k) in and of itself is not an investment. It's more like a box or a wrapper that contains investments for its participants to choose from.

But before you get to the point of picking the investments offered by your plan, you have to figure out what percentage of your paycheck will go into your 401(k) account. Because those contributions are made pretax, the more you sock away, the more you reduce your taxable income and, in turn, your tax bill.

"Some people might not appreciate stuff like the growth of their money or that this is [a way to save for] retirement, but it's the tax break that gets them," Genkin said.

The pretax contribution limit for 2017 is unchanged from last year: $18,000 for workers under age 50 and $24,000 for people age 50 or older (the extra $6,000 is called a "catch-up" contribution). Uncle Sam won't collect taxes on this money or associated earnings until you make withdrawals, at which point they are subject to your then-current tax rate.

Financial advisors say it's also important to know whether your employer makes a matching contribution to your 401(k). Some employers will match dollar for dollar; others will give you a percentage of your contributions (say, 50 cents for each dollar you put in) up to certain amounts.

"It's free money," said CFP Robert Schmansky, a personal financial advisor and founder of Clear Financial Advisors. "It could be an immediate 50 percent or 100 percent return on your contributions."

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Advisors say that some people mistakenly think the Internal Revenue Service contribution limits include employer matches.

"Those limits are only the employee's tax-deductible limit," said Genkin of My Financial Planner. "That doesn't have anything to do with an employer match."

The employer match sometimes comes with stipulations that you must be at the company for a certain number of months or years before that match vests, which is when the employer money is yours to keep.

Sometimes the vesting schedule is gradual, meaning a certain percentage of the employer match becomes yours after a set time (say, 50 percent vested after two years on the job) and then fully becomes yours at another set time.

Advisors also stress that even if you leave a job before the company match vests, the contributions that come from you are always yours to keep, regardless of how long you worked there.

"Sometimes people think they shouldn't bother investing in their 401(k) because they won't be at that company for the long term," Genkin said. "But it matters to start saving for retirement early, even if you don't think you'll be at the job for a long time."

One of the worst mistakes that workers make when they leave the job is withdraw their 401(k)'s balance instead of moving it ("rolling it over," in industry parlance) to an individual retirement account, advisors say.

"It's a colossal mistake," Genkin said. "You've just undone all the good things you did by saving, and you've maimed yourself."

Not only have you just taken your own retirement money but you'll also get slapped with a 10 percent early withdrawal penalty on top of paying income taxes on the withdrawal.

Roth 401(k) plans, which some employers offer, operate under different taxation rules from traditional 401(k) plans. The money you contribute to a Roth comes from your after-tax income, so withdrawing from a Roth avoids taxation but not the early withdrawal penalty (with a few exceptions).

If your employer does offer both a traditional 401(k) and a Roth 401(k), talking to a financial advisor or tax planner is the best way to determine which you should choose.

"If you're just starting out in your career and you're in a lower tax bracket than you'll be later in life, it might make sense to contribute to a Roth with after-tax money and pay a lower tax rate on it now," said CFP Roger Ma, founder of Lifelaidout. "It really depends where you are on the tax spectrum and trying to forecast where you'll be in retirement."

Also be aware that your plan might have different rules for company matches in Roths, advisors say.

If you're just starting out in your career and you're in a lower tax bracket than you'll be later in life, it might make sense to contribute to a Roth with after-tax money.
Roger Ma
founder of Lifelaidout

Once you understand your contributions, company matches and the vesting schedule and you understand the taxation of your contributions, you can move on to making sense of your plan's investment options.

Some plans have only a few investment options, while others have literally hundreds. While it's hard to generalize them because 401(k) plan offerings run the gamut, any choice you make for investing in a portfolio or mutual fund should be based on your age and your risk tolerance.

The younger you are, the riskier you can afford to be. That is, if you can stomach market swings, you're generally better off in stocks — which historically have returned more than bonds over time — for the long term.

But, advisors caution, knowing exactly what investments are held by a portfolio or fund involves looking under the hood.

"Sometimes people just pick based on the name of the fund and not realize the name means nothing," said Genkin of My Financial Planner.

It's not too late to lower your 2016 tax burden
It's not too late to lower your 2016 tax burden

Meanwhile, workers are seeing more and more so-called target-date funds among their investment options. These funds' assets automatically shift to more conservative investments as retirement nears. So a 2050 fund would invest aggressively in more volatile things, such as stocks in 2017, but would be mostly in safer bonds and fixed income by 2050.

"If you absolutely don't know where to turn, a target-date fund is a decent option to give you some broad diversification, so it's a good starting point," said Schmansky of Clear Financial Advisors. "But they tend to be cookie-cutter and not personalized to you."

Some advisors say that while people often are bewildered by their 401(k) plans and their investment options, it's no fault of their own.

"People get handed a manual that makes their heads spin," My Financial Planner's Genkin said. "It's just a matter of defining some terms for them and giving them some things to think about for their own situation to get things going."

— By Sarah O'Brien, special to CNBC.com