When it comes to thinking about retirement, a 401(k) plan is probably one of the options most familiar to your clients. But just because they are familiar with the term doesn’t mean they understand the ins and outs of a 401(k) plan and the role it plays in their retirement planning. Setting up a 401(k) may be one of the first steps a client takes to start thinking about long-term retirement planning goals.
Use these common questions as a guide to help your clients better understand their 401(k). Better yet, take their questions as an indication to slow down and ensure they completely comprehend how it works. Moreover, help them see how a 401(k) may be an important part of the overall retirement planning process.
What is a 401(K)?
A 401(k) is an employer-sponsored retirement plan that offers some up-front tax benefits, but make sure your client realizes what that means for their wallet and their taxable income.How does a 401(K) work?
You may find that clients signed up for a 401(k) when they started with an employer as part of the benefits package, but didn’t really understand how the plan works. There could be an opportunity to revisit their elections and discuss planing for adjustments that may better align with current goals.How does 401(K) matching work?
Encourage your clients to check the exact details of contribution matching. Help clients understand what it means when a 401(k) match is often described as “free money.” Employers may offer predefined matching contributions such as a percentage of contribution or dollar-for-dollar match-up to a certain percentage or defined amount.
Vesting is something else you can highlight with your clients. Ask if they have a vesting option in their plans and explain to them the difference between full vesting and the impact that can have if they choose to borrow from their 401(k) or suffer from an unexpected job loss.
What are the 401(K) 2019 limits?
The Internal Revenue Service (IRS) puts a cap or a limit on the amount of money individuals can contribute to their 401(k)s each year. Since this amount can vary from year to year, it’s a great opportunity to revisit your clients elections on an annual basis. In 2019, the limit is $19,000.
However, for those who are age 50 and over, the IRS allows additional contributions – up to $6,000 in 2019 – called “catch-up contributions.”
Employers can currently contribute an additional annual maximum of $37,000 for a combined “all sources” contribution of $56,000 ($62,000 for those age 50 or older).
Since these contribution rates are often tied to inflation, it is important that your clients understand that the numbers are likely to go up in the coming years and what impact that may have on their overall retirement plan. Since their purchase power will likely be reduced over the course of their retirement, discuss strategies you can take to help mitigate those losses. One might include downsizing their home, for example.
How will 401(K) withdrawals be taxed?
Another conversation to have sooner rather than later with your client is how distributions are taxed. It’s critical to remind clients that contributions were not taxed when they went into the plan, and when it comes time to withdraw from a 401(k), distributions are taxed as ordinary income.
It’s also important that your clients understand that they should wait until they are at least 59 1/2 before withdrawing. If they don’t, they’ll have to pay taxes on both the money distributed plus a 10 percent early withdrawal penalty.
On the flip side, for those clients retired and over the age of 72, they need to understand that they must take what’s called a required minimum distribution (RMD). Otherwise, there will be a substantial tax penalty applied.
How much can I borrow against my 401(K)?
If your clients are asking about this option, it could be an indicator that something has happened related to their finances and you should probably encourage a broader discussion regarding their options. While it’s often not a good idea, an individual can borrow, tax-free, from their 401(k). Usually the amount is up to $50,000 or 50% of their vested amount, whichever is less.
When a client experiences financial burden, or a sudden loss of income or investments, many find it tempting to tap into their 401(k). However, it’s also important they understand the potential downsides of borrowing against a 401(k).
Any money borrowed from a 401(k) must be paid back. Remind your clients that while the dollars they put into their 401(k) were pre-tax, the money they will use to pay back the loan will be post-tax. If the money is not paid back, there’s a missed payment or they are unexpectedly laid off, the situation could change dramatically. Their plan provider could choose to continue the repayment plan but most likely clients who borrow will be required to repay the loan by the tax-filing deadline for the year of the withdrawal. If not repaid within this time, the loan becomes a distribution and would be taxed as such come tax day.
Additionally, there is also the risk of lost opportunity for growth for the money that is not in the account. For many people, that side of the borrowing discussion is often ignored or glossed over, but it can have long-term consequences on retirement income.
What happens to my 401(K) when I leave my employer?
If an employee leaves a job with a 401(k), they have a few options available. They can leave the money where it is, combine it with a plan from the new employer (if allowed by the new plan) or roll it over to an individual retirement account (IRA) – another way to save for retirement. It is important to remind clients that if they have any outstanding 401(k) loans, they may have to repay in full by the tax-filing deadline or take that loan as a taxable distribution. Make sure they also understand that while 401(k)s can usually be left with a former employer, most plans do not allow for continued contributions outside of employment and if so, they may not be able to maintain a loan repayment plan, if applicable.Can I get a 401(K) on my own?
For your clients who are self-employed, it’s possible to set up a solo 401(k). This works essentially the same way as an employer-sponsored 401(k) except it has a much higher individual contribution limit – $56,000 in 2019 with an additional $6,000 for those 50 and older.
Helping your clients understand the benefits of a 401(k) is just one part of their long-term retirement planning. Read more about helping your clients prepare for retirement with this checklist for creating an annual review.
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