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Imagine you've just started your first job, or perhaps you're beginning to consider saving for retirement. Your company offers a 401(k), but you're unsure where to begin (or even what it is).
Here's all the essential information you need to get started.
What exactly is a 401(k)?
In simple terms, a 401(k) is a retirement savings plan provided by your employer.
You contribute a portion of your paycheck every month to this account, where you can invest in various options (such as stocks, bonds, or mutual funds). Over time, your savings accumulate and ideally grow, allowing you to build a significant amount for retirement.
The returns you make on your 401(k) investments aren't taxed until you take the money out—preferably after you've retired.
Why should I consider having one?
Retirement savings may seem dull, but they're crucial, and it's wise to begin as soon as possible. Even saving just $50 each month can make a significant difference over time.
With a 401(k), your employer may offer to match a portion of your contributions, which is essentially free money. Additionally, because the money you invest is 'pre-tax'—meaning it’s deposited into your 401(k) before taxes are deducted—you can lower your annual tax burden.
However, you'll eventually need to pay taxes on this money when you start withdrawing it in retirement.
How do I choose my investments?
When you open your 401(k), you'll need to select your investments. Your employer typically partners with an investment broker to provide a list of available options. This means you’re limited to the options they offer, which can sometimes be less than ideal.
Either way, you’ll need to choose a fund from the list that matches your preferred level of risk. Here are some of the most common options you may want to consider:
Stock Funds: These funds focus on a variety of stocks, allowing you to invest a portion of your account into them.
Target-Date Funds: These funds are straightforward. You choose your retirement target date, then select the corresponding fund. They require little maintenance, as the fund automatically adjusts your investments over time to match your risk level with your age. Be aware that target-date funds may have higher fees compared to stock funds.
Blended-Fund Investments: These funds maintain a specific ratio of stocks to bonds. You can select one that aligns with your personal situation, taking into account your risk tolerance and how many years are left until your retirement.
Bonds/Managed Income: These funds are designed to protect your money, but they offer little growth potential.
Money Market Funds: These funds offer minimal growth, often failing to outpace inflation. Some accounts may temporarily place your contributions in a money market fund until you make your investment choices, but they are not suitable for long-term investing.
Take a look at our full guide to effortless investing for advice on which funds to begin with.
How much should I contribute?
When determining how much to invest, it’s important to consider your budget and income. However, there are a few additional factors to keep in mind:
Employer Match
Once again, your employer is essentially handing you free money, so it’s important to make the most of that opportunity. The Art of Manliness demonstrates just how much you can earn with an employer match:
Imagine earning $50,000 annually and your employer offers to match your 401(k) contributions dollar for dollar on the first 5% of your salary. You decide to invest 10% of your salary into your 401(k). That means you’re contributing $5,000 from your own pocket into your 401(k).
Next, your employer contributes its match. It matches your contribution dollar for dollar up to 5% of your salary, so your employer adds $2,500 to your account. That’s $2,500 in FREE money and a 50% return on your initial $5,000 investment.
The more you can take advantage of this match, the better. At a minimum, try to contribute enough to qualify for the employer match.
Contribution Limits
There are limits to how much you can contribute to your 401(k). For 2020, employees under 50 can contribute up to $19,500 annually. If you're 50 or older, the limit increases to $26,000.
However, with an employer match, you can exceed your individual contribution limit. The total maximum contribution—including both your savings and your employer’s match—can go up to $57,000. For those over 50, that limit is $63,500.
Common 401(k) Mistakes to Avoid
Investing in a 401(k) is relatively simple with some basic understanding and support from your employer. Still, there are several common mistakes that people often make with their 401(k) accounts:
Failing to take full advantage of your employer’s match
If we haven’t emphasized this enough, it’s free money, and you should grab it whenever possible.
If you feel you don’t have enough money to invest, that’s a different issue. However, if you can find a way to cut back a little in your budget to make room for investing, it can really pay off—especially if your employer is also contributing.
Not changing your default investment option
When you first open a 401(k), you're often assigned a default investment option. Sometimes, this might be a money market fund, which doesn’t offer much growth. The default option is typically not tailored to your specific needs or risk tolerance, so be sure to choose the funds that suit you after opening your account.
Forgetting to rebalance
You don’t want to frequently shift your investments, but it's a good idea to periodically review them and consider if they need to be rebalanced. Maybe when you first chose your funds, you took on too much risk or not enough. Or perhaps as you age, it’s time to adjust your portfolio to include more conservative options.
Forgetting to roll over
If you leave your job, don’t forget to move your 401(k). It may seem like a no-brainer, but a lot of people overlook this and leave their old 401(k) behind when switching jobs.
When setting up a new retirement account, or enrolling in one at your new job, you’ll have the option to roll over your old 401(k) funds. Be sure to request a direct rollover to avoid taxes and penalties.
If your new employer doesn’t offer a retirement plan, you can transfer your 401(k) balance into an IRA. In some states, 401(k)s provide better protection against creditors than IRAs, so if that’s a concern or if your current 401(k) has great options, it might be best to keep the funds where they are.
Investing too much in employer stock
You should limit your exposure to employer stock to maintain balance in your 401(k). Putting too much of your funds into the stock of the company you work for can result in an unbalanced portfolio.
To give you a guideline, financial advisors often recommend keeping no more than 10 percent of your portfolio in company stock. For a more diversified approach, consider using low-cost stock funds instead.
Other things you should know about
There are a few additional things to keep in mind if you’re new to managing a 401(k).
401(k) loans
You have the option to take out a loan from your 401(k), allowing you to access your funds before retirement. However, this comes with significant downsides. Many financial experts strongly advise against it because it can put you at a serious disadvantage in terms of building your retirement savings.
Additionally, you’ll incur interest and fees. Most plans charge a one-time fee of $75 and require at least 1% in interest. The silver lining is that the interest you pay is returned to your own account.
Another disadvantage to borrowing from your 401(k) is the possibility of double taxation. Repayments must be made with post-tax dollars, and you’ll still be taxed when you withdraw the money during retirement.
Fees
It’s crucial to keep in mind the fees tied to your 401(k) investment choices. The main fee you’ll come across is the expense ratio, which is the cost you pay to the entity managing the fund you've invested in.
A general guideline is to aim for expense ratios that are below 1%.
Starting a 401(k) might feel overwhelming at first. However, once you grasp the fundamentals and know what to watch for, it becomes much less daunting.
