Most professional jobs these days provide 401k accounts to the employee. However, employees–especially us young’uns that haven’t seen this stuff before–are often confused about what to do with this account. There are a lot of considerations, like how much to put in there, where to invest your money, what your company match means, how vesting works for that match, and whether you should take the Roth or Traditional option. I’ll guide you through all of these decisions to help you get the most out of this awesome account!
Why Contribute to a 401k?
The two best reasons to contribute to a 401k are to pay less in taxes, and get your employer match.
A 401k is a type of tax-advantaged retirement account. Tax-advantaged means that the account has special exceptions in the tax law that help you make the most of your money. There are two types of 401k account: Roth and Traditional (your employer might offer both, or just Traditional). I’ll delve into more detail on how to choose between the two later in this post, but for now let’s try to understand them individually.
Traditional 401ks work by allowing you to deduct money pre-tax from your paycheck. That means that you won’t pay any tax on the money that goes into your 401k this year, and your income (for tax purposes) is reduced by the amount you contributed. That money will then be invested, and grow over the course of your working life until you reach retirement age (which is age 59.5). You can’t access this money before that age without paying a 10% penalty (actually, there are ways to access some of it if you’re trying to retire early, but that’s a much more advanced topic that we’ll leave for another time). When you cash out your money to pay for your living costs in retirement, that’s when you’ll pay taxes. You’ll owe normal income tax (just like you would for job income) every year on the amount that you withdrew during that year.
Roth 401ks work by allowing you to pay tax now, and not have to pay tax when you retire. You’ll contribute to the account with after-tax dollars from your paycheck, and those will be invested in your account. They will then grow over time, and when you reach age 59.5 you will be able to withdraw the money penalty-free AND tax-free.
Another great reason to contribute is that employers often offer matching on your 401k contribution. This means that your employer will put in some amount of their money whenever you put in some of your money. They do this to encourage you to save for retirement, and to make themselves seem like a nice company to work for. The most common structure of these programs is that your employer will match 100% of your contributions (that means they’ll contribute a dollar for every dollar you put in) up to a certain percent of your salary. For example, the policy might be that they’ll contribute 100% up to 5% of your salary; if you make $100,000 a year, that means for every dollar you put in, up to $5,000, they’ll put in a dollar too (making for a total amount of $10,000 put in your account). Other companies will offer less than 100% matching, for example 50% matching up to 6% of your salary, which means you’ll get $0.50 cents from your employer for every dollar you contribute up to 6% of your salary. This is free money and is something you should make sure to take advantage of!
Some employers will have your company match on a vesting schedule. This means that the company match isn’t really yours until you’ve reached the vesting time (typically 1 year after the match was made). If you leave the company, you lose any unvested match. Your company’s 401k policies should tell you if your company match has a vesting schedule, and what it is.
How Much Do I Contribute?
The maximum amount you can contribute is (as of 2015) $18,000 per year. This number gets increased from time to time to keep up with inflation, prior to 2015 it was $17,500. This amount counts only your contributions, not your employer’s match. Should you contribute the full amount? Well, that depends on a few things:
- The investment options available for your account (I’ll explain shortly how to tell a crummy investment from a good one). If your options are crummy, you want to contribute enough to get your employer’s full match amount (so if they match 6% of your salary, you’d better contribute 6% and get that FREE MONEY!), and after that prioritize your Roth IRA (this is an individual retirement account not tied to your employer). Only after you’ve maxed out your IRA (which has a contribution limit of $5,500 a year) should you put the rest of the money you want to save for retirement into your 401k.
- Your budget: How much money can you spare out of every paycheck to put toward retirement? While I strongly encourage you to contribute as much as you can (and I practice what I preach! I’m putting $18,000 into my 401k this year!), for some of us that’s not feasible. You should absolutely have a budget, at least an approximate one, that tells you where every dollar is going to go. Whatever is left over after you pay for your expenses should go to some kind of savings, but choosing whether it should go into your 401k or your new car fund is a challenging question. It will depend on your specific needs and situation, but I encourage you to make retirement a priority. Even when saving for other big goals, 10% is often recommended as a rock-bottom amount you should put toward retirement from each paycheck (more is better). When you choose not to use tax-advantaged space in a given year, you can never get it back, and retirement is sooner than you think!
Ok, I Contributed, What Do I Invest In?
After you decide you’re going to put money into your 401k, you have to decide what you’re going to invest it in. Generally, the bank/company managing your 401k (places like Schwab or Fidelity) will provide you with a list of mutual funds to choose from (a mutual fund is a collection of different kinds of stocks or bonds that you can buy a piece of, its function is to help you avoid having to pick out individual companies to invest in yourself). I’m going to teach you three things about how to pick from these possibilities:
- Diversification: You may have heard the expression “diversify your portfolio” before. What this means is: you don’t want to be invested all in one company or section of the market. The main reason for this is to minimize the risk of all your investments crashing at the same time. For example, if you hold shares in Tesla, and shares in BP, and the US government announces new pro-electric-car legislation, your BP stock will take a dive, but your overall portfolio might be saved by the amount Tesla rises in response. However, mutual funds that are focused on a specific segment of the U.S. market aren’t usually the safest choice for retirement investment. Common examples of this type of fund are a fund composed of pharmeceutical company stocks, or technology company stocks. Instead I encourage you to look at index funds, which track much broader swathes of the market (and thus are better diversified). Index funds also have low fees, which I’ll discuss in #2. In addition to stocks, there are also bonds, which are a safer but slower-growing investment, and I will talk about these more in #3. For more in-depth information on how to diversify well, try this wiki.
- Expense Ratios: Expense ratios are fees attached to mutual funds. They are a percentage of the fund’s assets which are sold to pay for the operating expenses of the fund each year (pay the fund managers’ salaries and such). The expense ratio of a fund cuts into your returns. If the value of your fund grew 10% this year but your expense ratio was 1%, your effective rate of return was only 9%. That might not seem like a lot, but over the several decades your retirement money is going to sit there, it winds up being quite substantial! If you max out your 401k every year for 20 years, the difference between a 10% and 9% growth rate is over $100,000. Look for funds with low expense ratios. The lowest are index funds like the Vanguard Total Stock Market Index, whose current expense ratio is 0.05%. It only goes up from there, with some funds’ ratios reaching around 2% (these funds are cheating you out of your money). In general keep your expense ratios as low as possible without sacrificing diversification. I pretty much steer clear of most things over 1%, as a rule of thumb, but index funds should be much less (0.2% or less is probably a good guideline). If your 401k doesn’t have any/more than a couple low-cost funds, after you contribute enough to meet company match, you’re probably better off investing in your Roth IRA (where you can pick your funds with much more freedom) before contributing any more to your 401k.
- Growth vs Risk: Certain investment vehicles, like stocks, tend to grow and relatively high rates (something like 6-10% a year), but are also pretty risky (remember the 2008 crash?). Other investments, like bonds or money market funds, grow much more slowly (bonds grow at a couple percent a year, and money market interest rates are the same ~1% interest rates we see on savings accounts these days), but are much less risky. You need to manage this risk by having a little bit of both in your portfolio. An oft-repeated rule of thumb is have your age in bonds as a percentage of your investments (for example, at age 24, have 24% bonds in your portfolio). I personally think this is overkill and that people in their twenties should have a much larger amount in stocks, since there is a lot of time between now and retirement for your investments to recover from any crashes, but it’s completely up to your individual risk tolerance. If you’re terrified of losing money, put more in bonds. If you’d rather take on a little more risk to see your investments grow more quickly, do more stocks.
I hope you have found this a useful introduction. How do you approach retirement savings? Does your employer have a good 401k, and do you participate?