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Financial advisors are required to pass a stringent testing system imposed by FINRA (Financial Industry Regulatory Authority) in order to practice their trade. For those seeking to become financial advisors, here are five critical things that every financial advisor know about 401(k) retirement accounts.
401(k) Accounts are Employer-Sponsored
Unlike Individual Retirement Accounts (IRAs), a 401(k) account is created by an employer for an employee that is considered full-time. The 401(k) is called a 401(k) because it is named after section 401(k) of the Internal Revenue Service code.
The IRS began allowing 401(k)s in the early 80s as an attempt to keep employers from defaulting on pension plans they had established earlier. Many companies had put these pension plans into place and then did not have them fully funded when retirees asked for their pensions because markets performed poorly during the 70s.
According to Learnvest, 401(k) accounts have now been implemented by over 94 percent of all employers. In fact, many employers incentivize employees to contribute to their retirement account by offering a salary match up to a certain contribution percentage.
Some employers allow their employees to choose from a pre-set number of investments while others only allow their employees to contribute and instead have an investment company manage the corporation’s retirement accounts.
There Are Two Types of 401(k)s
If you aren’t already confused, there are actually two types of 401(k) accounts: Traditional and Roth.
Traditional 401(k)s allow employees to make pre-tax contributions straight from their paychecks that grow tax-deferred until retirement and that reduce taxable income now. Roth 401(k)s allow an individual to make post-tax contributions to their retirement accounts. Earnings from this type of account are not taxed at retirement.
Choosing the Right 401(k) Isn’t Black and White
As with most things in the black and white, there aren’t cut and dry answers for whether an individual should pick a Traditional 401(k) or a Roth 401(k).
Typically, an individual who is looking to save money on taxes now and who believes they will be in a lower tax bracket when they retire will want to invest using a traditional account. An individual who believes that they will be in a higher tax bracket when they retire may want to forego the current tax benefits of a traditional account and opt for a Roth account.
Thankfully, CNN Money also recently wrote a great piece that can help an individual determine which type of 401(k) is write for them.
Clients Should Never Withdraw Early
Retirement accounts are meant for retirement. An employee should never withdraw money from their 401(k) before reaching retirement age (which is currently 59.5 years old). In the event that they do, the IRS assesses a 10% penalty charge for withdrawing early on top of taxing all of the funds that are withdrawn at the individuals ordinary income tax rate.
The one exception to this is that Roth contributions can be withdrawn tax-free at any time. However, earnings from a Roth account cannot be withdrawn without facing penalties.
401(k)s Use Index Funds and Target Date Funds
The goal of most 401(k)s is to keep expenses low and for returns to be reasonably good. As a result, many 401(k)s only invest in super-cheap index funds (i.e. funds that track a market or sector) or target-date funds that change their investments as an individual nears retirement age to be more conservative.
While a financial advisor can recommend riskier alternatives for a 401(k) that could potentially produce higher returns, it is typically not a good idea to recommend any investment to a client that is not suitable for that client or that could potentially harm the client’s retirement fund.
Putting it All Together
For those looking to become financial advisors, know that it is a very difficult but rewarding job. It is a burden to manage others money because you know how much it matters to do well, but it can be absolutely delightful when things turn out the way that you hope they would.
By studying the five things that every financial advisor should know about 401(k) accounts listed above, you may be able to get a better idea of whether or not financial advising is truly a career that you would like to pursue.
Related Resource: Top 10 Best Online Master’s in Finance Degree Programs
