5 Common Myths About 401(k)s
Written by
Jake Safane
Edited by
Cory Dudak
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For many people, preparing for retirement involves saving and investing through their workplace retirement plan, such as a 401(k). There, you can set aside a percentage of your income to automatically get deducted from your paycheck and go toward certain investments, such as mutual funds.
While that might sound relatively easy, 401(k)s have particular rules that affect how these accounts can be used and taxed. These can include plan-specific rules or nuances, like how different 401(k)s have different investment menus and fees, along with overarching tax rules from the Internal Revenue Service (IRS).
These rules and variances among different 401(k) plans can create complexity and sometimes misunderstandings. 401(k)s also sometimes carry a reputation around how they can or should be used.
As such, some people come to believe certain 401(k) myths, such as the following:
1. You Have To Roll Your 401(k) Into an IRA if Leaving Your Employer
Because you access a 401(k) through your employer, it might seem like changing jobs means you can no longer keep retirement money with your previous employer’s plan. Many people end up rolling 401(k) funds into an individual retirement account (IRA) after leaving their employers, but that’s not always required.
For one, your previous employer might allow you to keep your 401(k) funds in their plan indefinitely. Your new employer’s plan might also enable you to roll your old 401(k) funds into a new 401(k).
If you have these choices, “there’s no black and white answer” in determining which one to choose, said Logan Allec, CPA and owner of Choice Tax Relief. That depends on factors like what the 401(k) fees are for your particular plan and the fund options within the plan, he added.
If your previous employer’s plan offered funds with lower fees than your current employer’s plan, for example, then you might end up with a larger retirement portfolio by leaving your old 401(k) intact.
2. You Have To Leave Money in Your 401(k)
Another myth, which is opposite to thinking you always need to roll your funds over, is that you have to leave your money in your 401(k) after you change jobs or when you retire.
As Allec noted, some people think they can’t touch funds from an old 401(k). In reality, you can move funds at any time. There are some tax nuances to understand, such as penalties on early withdrawals and time limits to avoid extra taxes if you pull funds from one 401(k) before depositing them into another retirement account. But one remedy is to make a direct rollover via an electronic transfer between retirement account providers, said Allec.
You also don’t have to leave your money in your 401(k) when you retire.
“While some 401(k)s may have a wide selection of investment choices with reasonable expenses, rolling your 401(k) into an IRA at retirement gives you almost unlimited choices from buying Treasury bonds to high growth stocks or funds at low expenses if chosen wisely. This flexibility allows you to generate the income you need in retirement while respecting your risk tolerance,” said Brad Hartman, owner of Hartman Financial Planning.
3. You Can Only Use a Traditional 401(k)
Many people know that there are both traditional and Roth IRAs. But not everyone realizes that Roth 401(k)s also exist, noted Allec. Although not every employer offers both traditional and Roth 401(k)s, you might be surprised to find how widespread these have become.
According to the Plan Sponsor Council of America, 90% of 401(k) plans allow for Roth contributions, although employer matches often still go into traditional accounts, so you could end up with both a traditional 401(k) and a Roth 401(k).
If you do have the choice of which account to save for retirement in, picking one depends on your tax situation.If you’re in a high tax bracket now and anticipate having less income in retirement, then you might prefer to use a traditional 401(k) so you can save money on taxes now. But if you expect your income to be higher in retirement than it is now, it could be to your advantage to use a Roth 401(k), as the money gets put in post-tax initially but can be withdrawn tax-free in retirement.
4. 401(k)s Are the Only Place You Should Invest in Stocks
Allec found that another common myth people hold about 401(k)s is that these are the only accounts where you should be investing in stocks. The reasoning behind this could be somewhat psychological, as perhaps someone is fearful of losing money in a brokerage account because it feels more immediate than what happens in a retirement account.
In many cases, though, you can buy the same or similar funds inside and outside of a 401(k), said Allec, and there could be good reason to invest elsewhere, depending on factors like your tax situation. Ultimately, the decision is personal, but there are often good reasons to invest in stocks in other types of accounts besides just your 401(k).
5. You Should Only Save for Retirement in a 401(k)
Similar to the myth that 401(k)s are the only place to invest in stocks, some people think you should only save for retirement in a 401(k). But it can make sense for some people to put money into different types of accounts, such as those that have different tax benefits like Roth IRAs and health savings accounts if eligible, rather than putting everything into a 401(k).
“While saving the maximum for retirement is a great idea, and you definitely want to contribute enough to max out your employer’s matching contributions, you may want to consider other choices above that level to give you more choices in investments and taxation and possibly lower costs,” said Hartman.
For example, if your 401(k) plan only offers mutual funds with high fees, you might decide to contribute enough to maximize your employer match and then invest in lower-cost funds within an IRA.
Educate Yourself To Grow Your Retirement Savings
While these 401(k) myths are common, you probably don’t want to follow the herd and make mistakes that hold back your potential to enjoy retirement. Many 401(k) plans offer free resources that can help you understand how to use these accounts and how they fit into your overall financial picture. You can also speak with an external professional such as a financial advisor or tax advisor to clarify how to invest within a 401(k) based on your situation.
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