How Does Your 401(k) Work? Some Basics

To me, understanding how a 401(k) works should be easier than reading a food ingredients label. You should know at a glance how your plan works.

Yet millions of retirement savers don’t have a clue, even though a 401(k) structure is simple: It’s a group of mutual funds where your money is pooled with thousands of others. Money managers and middlemen take a cut of your assets.

Well, honestly, there’s more to it than that, but that’s the basic framework. Many employers don’t do a decent job of explaining their retirement plans, nor do they educate employees on how to maximize them.

Not surprisingly, a recent poll showed that some 63% of workers don’t understand how their 401(k)s work.

Where do you start? Financial Planner Curtis Farrell suggests you explore the following documents, which your employer should provide:

— Summary Plan Description: a plain-language description of the plan that informs participants of their rights and responsibilities under the plan, along with its features and what to expect.

— Individual Benefits Statement: Provides participants with account balance and vesting information.

— Automatic Enrollment Notice (if the plan includes an automatic enrollment feature): details the plan’s automatic enrollment process and participants’ rights — must specify the default deferral rate, the participant’s right to change their deferral rate (or to opt out), and the plan’s default investment.

— Summary Annual Report (SAR): Provided annually to participants; summarizes the financial information in the plan’s annual report, the Form 5500.

What do you need to know from these statements? How soon will you be “vested” or fully enrolled in the plan? How much can you invest? How much are fund managers charging you for money management? How much are middlemen charging?

On those last two items, the lower the annual percentage — remember, this is money coming out of your kitty — the better. Getting total expenses under 0.50% a year is a reasonable goal.

The more you know about your plan, the more you can save. Education is essential in building your retirement fund.

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