Your employer said you can participate in the 401(k) plan. Great news! You just open the account and then… then what? What do you do with your 401(k) next?
In this blog, I am going to answer the following questions:
- What is a 401(k)?
- Why should I use a 401(k)?
- How much money should I put in my 401(k)?
- What investment options should I choose?
I hope my answers help you make decisions with your 401(k) that serve your financial future well!
1. What is a 401(k)?
A 401(k) is a type of retirement savings account that allows you to invest. 401(k)s are only offered through your employer. Not all employers offer one, so be sure to ask your employer if they do.
So, a 401(k) is simply a bucket filled with investments. The bucket fills up a little more every time you deposit into the account.
Usually, you will tell your employer you want X% of your paycheck put into the 401(k) every pay period. The money is deducted from your paycheck, put into your 401(k), and the bucket starts to fill!
If you look at your paystub, you will see the dollar amount deducted from your wages. It’s still your money that you earned – it’s just being redirected into a retirement account instead of your checking account!
2. Why should I use a 401(k)?
You need to have money saved up for retirement. You can’t count on Social Security alone to cover your expenses when you are no longer working full time.
The most efficient way to save money for retirement is with RETIREMENT ACCOUNTS (not too surprising, right?). The most-used retirement account for working adults is the 401(k).
So, other than simply being an account you can dump money into, what are the benefits??
a. Tax benefits
When your wages are put into your traditional 401(k) account, you are not taxed on those wages! You keep the money in your retirement account (tax free) and it grows and grows for years. You never pay taxes while the money is growing.
Now, there are two kinds of 401(k) accounts: a traditional 401(k) and a Roth 401(k). These different types have different tax benefits. I wrote a blog specifically focusing on helping you decide which one you want. Read it HERE.
b. It helps you save without thinking about it
I have always said that the best way to save is to do it without thinking about it. If you tell your employer to withhold 10% of your paycheck for your 401(k), it will just happen every paycheck. You don’t have to make the decision every week to save. The money just goes straight to the 401(k) where it will happily grow and wait for you to retire.
c. You might be able to get FREE MONEY $$$
No, this isn’t too good to be true. Many employers offer a “match” to encourage their employees to save (and try to retain talented employees). A 3% match is common. In which case, if you put at least 3% of your paycheck into your 401(k) account every pay period, your employer will match the contributions dollar for dollar. If your 3% was $50, then your employer would put another $50 of their own money in your account just to encourage you. That is the FREE MONEY you would miss out on if you didn’t contribute! It might not seem like a lot in this example, but trust me, it adds up quickly!
3. How much money should I put in my 401(k)?
This question is a little harder for me to answer, because it’s a little bit different for everyone. I dive into a deeper response in my blog How Much Do I Need to Save By Retirement.
The general rule of thumb is that you should save at least 10% of your income. Work your way up to 15% if possible. Now, there is an IRS limit of how much you can put into your 401(k) each year. Generally, it is the high-income earners who run into this limitation.
If you can’t afford to take 10% out of your paycheck, start lower. Do your best to get at least the full match. If your employer matches up to 3%, then make 3% your minimum goal. See if you can increase that by another 1% every year; work your way up to a healthy savings rate. If you get a raise, definitely increase your contribution!
4. What investment options should I choose?
A 401(k) seems simple until you are told to log in online and choose your investment options. This is where it can turn into a “deer in the headlights” moment. Sometimes, 401(k) plans offer you dozens of investment options! How do you know which options are right for you??
The answer if you’re not sure how to choose your investments: Talk to an investment professional. Some 401(k) plans have a designated professional for you to talk to. Other times, you must hire a professional on your own.
The answer for “do-it-yourselfers”: There are likely pre-made portfolios available within your plan. Their name might include the year in which you are expected to retire. For people with an average risk tolerance and little interest to research investment options, these funds are the most likely to be suitable for you.
As you approach retirement, these age-based funds will age with you. Bonds are slowly added to the portfolio to bring more stability without you having to make any changes yourself.
If you have the interest, time, and knowledge to research the other investment options in the plan, you can try to build yourself your own diversified portfolio. If you go this route, please act with great prudence!
The benefit to working with a professional is that they can do this fund research for you. It is very possible (and likely!) that a mix of carefully selected mutual funds will serve you better than the age-based funds. However, it does take research to understand your risk tolerance and choose the investment funds that match.
Once you open your account and choose your investments, your 401(k) generally takes care of itself from there! Check the account periodically and call your plan administrator whenever you have any questions.
Remember that a 401(k) is for long-term retirement savings. You cannot take money out of the account until you are 59 ½, unless you have an approved reason. Note: if you take money from your 401(k) early and without an approved reason, there is a 10% tax penalty.
I hope this blog encourages you to take advantage of the savings program your employer offers, and if you haven’t yet, START SAVING!! 🙂