A Beginner’s Guide to Starting 401 (K)
Let’s say you’ve started your first job. Or maybe you’re just thinking about saving for retirement. Your employer offers 401 (k), but you don’t know where to start (or even what it is).
Here’s everything you need to know.
What is 401 (k)?
Simply put, a 401 (k) is a retirement savings account offered by your employer.
You save a certain amount of money from your salary every month and use it to invest through this account. You have the opportunity to invest in various assets (for example, stocks, bonds, mutual funds). Over time, your money grows. Ideally, when you retire, you will have a big stack of money that has grown over the years.
The money you make from your 401 (k) investment is tax deductible until you withdraw it – ideally after you retire.
Why do I need one?
Saving up for retirement is boring but important, and you should start saving as soon as possible. Saving even $ 50 a month can help you.
With a 401 (k), your company can offer an appropriate percentage of some of your 401 (k) contributions. It’s basically free money. Also, since the money you invest comes “before tax” – which means it gets transferred into your 401 (k) before income tax is debited – you can lower your annual tax bill.
Of course, when you retire, you will eventually have to pay taxes on that money.
How to choose an investment?
When you open your 401 (k) you will need to select your attachments. Your employer usually works with an investment broker to come up with a list of options. This means that you are stuck on the list they offer and sometimes not so much.
Either way, you will have to choose a fund from this list based on the level of risk you feel comfortable with. Here are some of the more common ones you are likely to consider:
- Stock Funds: As the name suggests, this type of fund encompasses various stocks in which you can invest a percentage of your account.
- Date Funds: These funds are pretty simple. You choose your retirement date and then you choose the appropriate fund. No special maintenance is required as the fund adjusts your asset allocation over time to match your level of risk and your age. Fund collections with a set date can be higher than for a fund.
- Mixed fund investments: These funds have a fixed ratio of stocks to bonds. You can choose the one that suits your situation. This means that you will have to consider your risk tolerance and the number of years before retirement.
- Bonds / Managed Income: These are funds designed to protect your money, but your money will not grow much with these funds.
- Money Market Funds: There is practically no growth here, and, in fact, these funds are barely keeping pace with inflation. In some accounts, your contributions will be held in money market funds until you choose your allocations, but you should avoid them when investing in the long term.
Check out our complete set-and-forget investment guide to understand which funds to start investing in.
How much should I invest?
When deciding how much to invest, you will obviously have to think about your budget and income. But there are a couple more things to consider:
Employer match
Again, your employer mainly gives you money, so try to use it as much as possible. The art of masculinity shows how much you can earn with an employer partner :
Let’s say you make $ 50,000 a year and your employer says it will match you $ 1 for every dollar you deposit into your 401 (k) for the first 5% of your invested paycheck. You decide to save 10% of your 401 (k) salary. That’s $ 5,000 that YOU deposit from your pocket into your 401 (k).
And here is your employer’s contribution. It corresponds to your contribution in dollars per dollar up to 5% of your salary. This means your employer will deposit $ 2,500 into your account. That’s $ 2,500 of FREE money and a 50% return on your $ 5,000 initial investment.
The more you can take advantage of this, the better. But at least consider depositing the minimum amount needed to get a match.
Contribution limits
There are limits on how much you can save in your 401 (k). In 2020, you can only deposit a maximum of $ 19,500 out of pocket per year (for employees aged 49 and under). If you are over 50, the limit is $ 26,000.
But if you have an employer match, you can save more than your individual limit. The maximum combined contribution — the amount you set aside along with the employer’s match — is $ 57,000. For those over 50, this amount is $ 63,500.
Common 401 (k) errors 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:
Don’t take advantage of your employer
If we haven’t already done so, this is free money and you should take it if at all possible.
If you think you don’t have enough money to invest, that’s a whole different story. But if you can find even a small amount to cut in your budget to make room for investment, it can make a difference, especially if your employer is also contributing.
Do not change the default investment option
Often times, when you open a 401 (k), you are presented with the default investing option. Sometimes the money market fund is the default, which means almost zero growth. The default option is not customized for your needs and risk level, so be sure to distribute your assets (choose a fund or two!) After opening an account.
Forget to rebalance
You don’t want to move your assets around too much, but you should check your investments from time to time and see if you need to balance them. Perhaps you were too risky or not risky enough when you first chose the funds. Perhaps you have grown older and it is time to invest more money in less risky options.
Forgetting to roll over
If you quit your job, be sure to take your money with you. Sounds obvious, but a lot of people do this – they quit and forget about their old 401 (k) when they leave work.
When you open another retirement account or register for a new job, you have the option to renew your account. Make sure you are requesting a direct transfer to avoid taxes and penalties.
If your new employer does not have a retirement plan, you can transfer your balance to the IRA. In some states, 401 (k) plans offer better lender protection than an IRA, so if that’s a concern – or you have great options for your current 401 (k) – it might make sense to leave funds where they are.
Too much investment in employer stock
You want to cap your employer’s stock to keep your 401 (k) balanced. If you invest too much money in one company (the one you work for), you end up with a lopsided portfolio.
To put the figure, some financial experts recommend investing no more than 10 percent of your portfolio in your employer’s stock. To maintain a diversified portfolio, consider cheap equity funds .
Other Things You Should Know About
There are a couple more things to look out for if you’re new to 401 (k).
401 (k) loans
Yes, you have the option to take a loan from your account. You can withdraw money before retirement, but you have to pay for it. Most financial advisors say this is a really bad idea because you are putting yourself at a disadvantage to make up the difference before you need that money for retirement.
You will also have to pay interest and fees. Most plans charge a one-time commission of $ 75 and an interest rate of at least 1%. However, you get your interest back.
Another downside to borrowing from your 401 (k): you can tax yourself twice. The loan must be paid in dollars after taxes, plus you still have to pay taxes when you withdraw funds from your account at retirement age.
Fees
It’s important to consider the fees associated with your 401 (k) investment options. The basic fee you will face is the expense ratio you pay to the backer of the fund you have contributed to.
A good rule of thumb is to make sure your spending is under 1%.
Running your 401 (k) can seem like a daunting process. But once you grasp the basics and know what to look for, it’s not that scary.
This post was originally published in 2014 and was updated by Lisa Rowan on April 21, 2020. Updates include the following: verified links for accuracy; updated formatting to reflect the current style; updated contribution limits; modified content to be more concise.