401(k)'s Made Simple
The easy start guide
Part 10 | Reading Time: 4 minutes
By Ian Bin
Imagine in a dream world having a financial crystal ball that could provide you with a comfortable and secure future when you enter retirement. That seems impossible! But what if I told you that the closest thing to a crystal ball exists and goes by 401(k)? In this article, we’ll demystify what a 401(k) is and why you should care about it, because it’s not just another financial term – it’s the key to your financial freedom in retirement.
What is a 401(k)?
Let’s start simple! A 401(k) is a retirement savings and investing plan that most employers offer.1 It’s a way to save now so you have money when you are retired many years from now. The most common 401(k) plan type for starting is the traditional 401(k).2 Traditional 401(k)’s are tax-deferred, meaning you’ll be taxed on your contributions and growth when you withdraw years down the line.3
First steps for a 401(k)
Enroll
First, check if your employer offers a 401(k) plan. If they do, you’ll typically need to go through a process to enroll. They’ll give you the forms with the information you need to sign.
Contribution amount
In a 401(k), you choose how much money to contribute, usually to be deducted from your paycheck before taxes to put in your retirement account. This means you’re essentially reducing how much you can be taxed on your regular paycheck, which can have some nice financial perks today.4
But remember, this money is supposed to be taken out once you are in retirement; when you withdraw the money in retirement, that’s when taxes come into play if you go with a traditional 401(k). Keep your weekly budget for living in mind – you want to save enough without feeling the pinch.
Employer match
Some companies can offer an incredible little perk. Pay attention to whether your employer offers a match. What is an employer match? Employers offer a percentage (ex. 50%) extra contributions up to a percentage (ex. 5%) of your salary. For example, if you earn $60,000 and contribute 5% of your yearly income, that’s $3,000. With the match, your employer adds $1,500 for an overall total of $4,500 into your 401(k). That’s like free money for your retirement! The maximum you can add to your retirement is $22,500 (or $30,000 if you’re 50 or older) in 2023, but typically contributing the amount that your employer matches is the best bang for your buck.
Investment choices
When you have a 401(k), imagine it as a basket to hold your retirement savings. What you decide to put into the basket is up to you. What contributions you put into your basket don’t just sit there; they’re invested in different assets like stocks and bonds. That is how your 401(k) grows over time. Most plans will offer a variety of investment options. You’ll need to decide how to distribute your money based on your risk tolerance and your goals for retirement. So, every plan will always be tailored to you.
Most plans will offer 10 to 20 investment fund choices,5 each of which holds a diverse range of hundreds of investments, such as individual stocks, bonds, and cash, that are chosen based on a particular strategy (e.g., small growth companies) or market indexes, such as the S&P 500 or the Nasdaq.6 Before choosing a plan, be sure to do your research when it comes to choosing. Mutual funds are the most common type of investment offered by 401(k) programs.7 Although your employer sponsors the 401(k) plan, you are responsible for the account’s assets. If this sounds like a lot of work, you can get an advisor to help you manage it if the plan does not offer that option; be aware that it comes with a fee.
Vesting
It’s essential to keep an eye on the vesting schedule. You may be wondering what vesting is. Vesting determines how much of your employer’s contributions you get to keep if you leave the company before a specific period.8 It’s like a reward for sticking around. Every company has a different vesting period, so be sure to get more information for your company.
Keep an eye on it
Your 401(k) isn’t a set-it-and-forget-it deal. Be sure to check in on it periodically. As you get closer to retirement, adjust your investment choices to align with your current goals and risk tolerance. A 401(k)’s beauty lies in its compounding power. The earlier you start, the more time your money can grow. Even if you can only contribute a small amount now, it adds up over time thanks to those excellent compound effects.
Consider fees
There are certain investment funds that charge fees that can eat into returns, so you must consider these when choosing suitable funds. These fees are detailed in the fund’s prospectus. For example, mutual funds charge an expense ratio, a fee based on the amount you have invested in the fund.9 But different funds may charge other costs, too. It’s essential to consider the price related to the investment performance.
Planting seeds for the future
So, there you have it – a 401(k) demystified. Well, I hope you left here learning something you didn’t know about 401(k)’s. This doesn’t cover every little detail. Instead, this is more to get you started. This isn’t a test where you must remember everything. Think of this blog as a starting checklist so that when you begin your 401(k), you have a solid basis. Remember, it’s an investment in your future self. Your retirement dreams will thank you down the road 30 years from now.
Resources
1 Yochim, Dayana. “401(k): What It Is and How It Works.” NerdWallet, www.nerdwallet.com/article/investing/what-is-a-401k. Accessed 5 Sept. 2023.
2 Daugherty, Greg. “Beginner’s Guide to the Types of 401(k)s.” Investopedia, Investopedia, www.investopedia.com/beginners-guide-to-types-of-401-k-s. Accessed 5 Sept. 2023.
3 Freeland, Allie. “Roth vs. Traditional 401(k): What’s the Difference?” H&R Block, 20 Mar. 2023, www.hrblock.com/tax-center/income/roth-vs-traditional-401k/.
4 Bell, Amy. “401(k) Tax Benefits and Advantages.” Investopedia, Investopedia, www.investopedia.com/articles/investing/102216/understanding-401ks-and-all-their-benefits.asp. Accessed 5 Sept. 2023.
5 Royal, James. “How to Invest Your 401(k).” Bankrate, www.bankrate.com/retirement/how-to-pick-401k-investments/#picking. Accessed 5 Sept. 2023.
6 Yochim, Dayana. “How to Set up Your 401(k).” NerdWallet, www.nerdwallet.com/article/investing/how-to-set-up-your-401k. Accessed 5 Sept. 2023.
7 Scott, John. “Small Differences in Mutual Fund Fees Can Cut Billions from Americans’ Retirement Savings.” The Pew Charitable Trusts, The Pew Charitable Trusts, 30 June 2022, www.pewtrusts.org/en/research-and-analysis/issue-briefs/2022/06/small-differences-in-mutual-fund-fees-can-cut-billions-from-americans-retirement-savings.
8 “Retirement Topics – Vesting.” Internal Revenue Service, www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-vesting. Accessed 5 Sept. 2023.
9 Royal, James. “What Is an Expense Ratio and What’s a Good One?” Bankrate, www.bankrate.com/investing/what-is-an-expense-ratio/. Accessed 5 Sept. 2023.
2 Daugherty, Greg. “Beginner’s Guide to the Types of 401(k)s.” Investopedia, Investopedia, www.investopedia.com/beginners-guide-to-types-of-401-k-s. Accessed 5 Sept. 2023.
3 Freeland, Allie. “Roth vs. Traditional 401(k): What’s the Difference?” H&R Block, 20 Mar. 2023, www.hrblock.com/tax-center/income/roth-vs-traditional-401k/.
4 Bell, Amy. “401(k) Tax Benefits and Advantages.” Investopedia, Investopedia, www.investopedia.com/articles/investing/102216/understanding-401ks-and-all-their-benefits.asp. Accessed 5 Sept. 2023.
5 Royal, James. “How to Invest Your 401(k).” Bankrate, www.bankrate.com/retirement/how-to-pick-401k-investments/#picking. Accessed 5 Sept. 2023.
6 Yochim, Dayana. “How to Set up Your 401(k).” NerdWallet, www.nerdwallet.com/article/investing/how-to-set-up-your-401k. Accessed 5 Sept. 2023.
7 Scott, John. “Small Differences in Mutual Fund Fees Can Cut Billions from Americans’ Retirement Savings.” The Pew Charitable Trusts, The Pew Charitable Trusts, 30 June 2022, www.pewtrusts.org/en/research-and-analysis/issue-briefs/2022/06/small-differences-in-mutual-fund-fees-can-cut-billions-from-americans-retirement-savings.
8 “Retirement Topics – Vesting.” Internal Revenue Service, www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-vesting. Accessed 5 Sept. 2023.
9 Royal, James. “What Is an Expense Ratio and What’s a Good One?” Bankrate, www.bankrate.com/investing/what-is-an-expense-ratio/. Accessed 5 Sept. 2023.
