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Let’s say you’ve started your first job. Or, maybe, you’ve simply started to think about saving for retirement. Your employer offers a 401(k), but you don’t know where to get started (or even what that is). Here’s everything you need to know.
What Is a 401(k)?
To put it in really general terms, a 401(k) is a retirement savings account offered through your employer. (If you’re self-employed, you can open a Solo 401k, but that’s a whole separate topic).
You set aside a certain amount of money each month from your paycheck, and use it to invest money through this account. You have the option of investing in a variety of assets (i.e. stocks, bonds, mutual funds). Over time, your money grows. Ideally, when you retire, you’ll have a big stack of money that’s been growing for years.
The money you earn from your 401(k) investments isn’t taxed until you withdraw it—ideally, after you’ve retired.
Why Do I Want One?
Saving for retirement is boring, but important, and you should do it as soon as you can. Saving even $50 a month can work for you.
With a 401(k), your company might offer to match a percentage of some of your 401(k) contributions. This is basically free money. Also, since the money you invest is “pre-tax,” you could reduce your annual tax bill. CNN Money explains:
Another benefit to having a 401(k) retirement plan is having taxes deferred until you withdraw the money at retirement. So, since the 401(k) actually reduces your tax rate, you won’t be paying taxes on the money until you withdraw it. Since many people tend to be in a lower tax bracket when they retire, the 401(k) actually has you paying a smaller tax rate on your savings when you take it out of the account.
Of course, you’ll eventually have to pay taxes on this money when you retire.
How Do I Pick My Investments?
When you open your 401(k), you’ll have to pick your investments. Your employer usually works with an investment broker to come up with a list of options. This means you’re stuck with the list they offer, and sometimes, the list isn’t great.
Either way, you’ll have to pick a fund from this list that’s based on a risk level you feel comfortable with. Investor Place runs down the five major types of funds you’ll likely have to pick from:
Stock Funds: As the name suggests, this type of fund covers a variety of stocks that you can invest a percentage of your account in. According to Investor Place,
“Most 401ks only offer a handful of stock funds to choose from, so selecting funds in this category shouldn’t be hard — just look at expenses (lower is better) and long-term returns (higher is better) to find the best fit.”
Target-Date Funds: These funds are pretty simple and basic. You pick your target date for retirement, then pick the matching fund. Because they’re so simple, there’s not much maintenance, as the fund adjusts your asset allocation over time. The fees of target-date funds might be higher.
Blended-Fund Investments: These funds have a set ratio of stocks and bonds. You can pick one that’s appropriate for your situation. This means you’ll have to consider your tolerance for risk and how many years you have until retirement.
Bonds/Managed Income: These are funds are meant to safeguard your money, but your money won’t grow much with these funds.
Money Market Funds: Investor Place calls the money market fund a “glorified CD.” There’s zero growth here, and, in fact, these funds barely keep up with inflation rates. They recommend avoiding money market funds if you want your money to grow.
Check out our complete guide to set-and-forget investing for an idea of which funds to start investing in.
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How Much Should I Invest?
When deciding how much to invest, you’ll obviously have to think about your budget and your income. But there are a couple of other points to consider.
Again, your employer is basically giving you money, so want to take advantage of that as much as you can. The Art of Manliness shows just how much you can earn with an employer match:
Let’s say you make $50,000 a year and your employer says he will match you $1 for every dollar you contribute to your 401(k) on the first 5% of your salary you invest. You decide to save 10% of your salary in your 401(k). That’s $5,000 that YOU contribute out of your pocket to your 401(k).
Now here comes your employer’s contribution. He’ll match your contribution dollar for dollar up to 5% of your salary. That means your employer will contribute $2,500 to your account. That’s $2,500 of FREE money and a 50% return on your initial investment of $5,000.
The more you can take advantage of this, the better. But at least consider contributing the minimum amount that’s required to make you eligible to receive a match.
Yes, there are limits to how much you can save in your 401(k). In 2014, you can contribute no more than $17,500 out of pocket for the year (for employees age 49 and below). If you’re over 50, the limit is $23,000.
But if you have an employer match, you can save more than your individual limit. The maximum combined contribution—the amount you save with your employer’s match—is $52,000. For those over 50, that amount of is $57,500.
Common 401(k) Mistakes to Watch Out For
With some basic knowledge and help from your employer, investing in a 401(k) is pretty straightforward. But there are some common mistakes people make with them, too.
Not Taking Advantage of Your Employer’s Match
If we haven’t already stressed it enough, this is literally free money, and you should take it if at all possible.
Sometimes people neglect to take advantage of this because they’re afraid to start investing. This is sort of what we’re addressing in this entire piece, but your employer’s “menu” of funds should make investing pretty straightforward.
If you don’t think you have enough money to invest, that’s another story. But if you can find even a small amount to cut in your budget in order to make room for investing, this can make a difference, especially if your employer is contributing, too.
Not Changing Your Default Investment Option
Many times, when you open a 401(k), you’re given a default investment option. Sometimes, a money market fund is the default option. This means little to no growth. The default option isn’t customized for your needs and risk level, so make sure to actually allocate your assets (pick a fund) once you open your account.
Forgetting to Rebalance
You don’t want to move around your assets too much, but every once in a while, you should check in on your investments and see if you need to rebalance them. Maybe you were too risky or not risky enough when you first picked your funds. Maybe you’ve gotten older, and it’s time to invest more of your money in less risky options.
Forgetting to Roll Over
If you leave your job, don’t forget to take your money with you. It sounds obvious, but many people do this—they leave behind and forget about their old 401(k) when they move on from a job.
When you open another retirement account, or sign up for one at your new job, there’s an option to fund the account through a rollover. Make sure you request a direct rollover to avoid being hit with taxes and penalties.
Forbes does mention another option, though:
If your former employer has a terrific 401k plan with lots of investment options, you may consider leaving it where it is. It’s important to consider any administrative fees that your former employer may pass on to its employees because they eat into your overall return.
In some states, 401(k) plans offer better creditor protection than IRAs, so if that’s a concern, it may make sense to keep the funds where they are.
Investing in Too Much Employer Stock
We’ve written about this before. You want to limit your employer stock to keep your 401(k) balanced. CFA Simon Moore said this is the single biggest problem with most people’s 401(k) plans: way too much of their portfolio is investing in their employer’s stock. This makes for a severely unbalanced portfolio, as it’s risky to invest your money in any one company.
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To keep a diversified portfolio, Moore suggests limiting investments in your company’s stock, despite your employer’s encouragement. He recommends investing in low-cost, broad stock funds instead.
To put a number on it, some financial experts recommend allocating no more than 10 percent of your portfolio to your employer’s stock.
Other Things You Should Know
There are a couple of other things to watch out for if you’re new to the 401(k).
Yes, you have the option of taking out a loan from your account. You can withdraw the money before your retirement. But most financial advisors say it’s a really, really bad idea. According to Bankrate:
Most advisers would call it an act of fiscal insanity, unless you’re genuinely trapped with no other financial lifeline available.
“Many people don’t have enough saved for retirement in the first place, and when they take their 401(k) out of the equation and borrow the money — typically up to 50 percent of their balance — then that money is no longer working for their retirement needs,” says financial planner Bob Mecca, president of Robert A. Mecca Associates in Prospect, Ill. “And the money is no longer growing, compounded and tax-deferred.”
You’ll also have to pay interest and fees. According to About.com, most plans charge a one-time fee of $75, and a common interest rate is around 1%. You are, however, paying the interest back to yourself.
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Another drawback to borrowing from your 401k: you might double tax yourself, which is as awful as it sounds:
While regular 401(k) contributions are taken out of your paycheck on a pre-tax basis, the loan repayments are not. This means that you are taking pre-tax money out of your account and then repaying it with after-tax money. This can result in some of this money being taxed twice.
401(k) fees are a sticky topic. We’ve talked about them before: it’s important to consider the fees associated with your 401(k) investment options.
You can use online calculators to determine and compare how much these fees will cost you over time. Check with your employer about the fees associated with each fund type. Calculate the cost, and see if it makes more sense to target a different kind of fund.
Starting your 401(k) can seem like a complex process. But once you understand the basics, and know what to look out for, it’s not so intimidating.