For some people, a 401(k) is a confusing and daunting task that you have to figure out when you start at a new company. Here is some helpful information to get you started.
What is a 401(k)?
A 401(k) is an investment account set up by your employer specifically for saving for retirement.
Many years ago employers offered pensions that would be paid out to an employee during retirement. These were specific to the employer and would keep an employee working long term at a company so that they could eventually collect this benefit.
Now many companies have replaced pensions with 401(k)s. These plans allow the employee to invest the money (pre-tax or post-tax) into the market. Depending on the 401(k) and how your employer set it up, you may have options for stocks, bonds, company equity, etc.
The big difference between a pension and a 401(k) is that the pensions are guaranteed (assuming the company did not mess it up). As long as you met the requirements you would be guaranteed the money. A 401(k) has no guarantees. You are investing in the market and can gain or lose money based on the economy and the choices you make.
The Basics
Traditional 401k vs Roth
The main difference between these two types of accounts is when you pay taxes. When you put money into a Traditional 401(k), you pay taxes when you withdraw from it in retirement. The money is pre-tax. On the other hand, for a Roth 401(k) you pay the taxes upfront. When you withdraw your money during retirement, it is tax-free.
Short and Sweet – How to Handle your 401(k)
If you do not want to think about your 401(k) then there are two main options for you.
- Have someone else manage it. Usually, 401(k) providers can provide you a resource to help you manage your 401(k). This comes with a cost (obviously). It is there if you do not feel comfortable about handling a 401(k) yourself. That being said there are some other pretty simple options that could save you on those extra fees.
- Target dated fund – Many 401(k)s have options called target dated funds. These are funds that update over time and go from more aggressive (more stocks) to more conservative (more bonds). You will most likely be able to see these options because they contain a year in the name. The year represents when you would “expect to retire”. While you may only be putting money into one fund, that fund contains different stocks and bonds across various markets. This type of fund is great for someone who does not want to focus on their 401(k) accounts. You should check the fees before investing in the account but as long as you are getting this fund through a major player like Fidelity or Vanguard the fees are probably reasonable. Also do not feel obligated to select the year that would be your “retirement” year. If you pick a year further in the future the plan will be more aggressive long term. A plan closer in time will obviously then be more conservative.
In-Depth – How to Handle your 401(k)
Get That Money (Match)
One important 401(k) factor is if your company has a match. So for example a company might match 100% up to 3%. This means if you put in 3% per paycheck your company will also put in 3%. The match can end up getting a little complicated. For example it could be something like 100% of 3% and then 50% up to 5%. Which works like this:
| Your % | Company Match % |
| 1 | 1 |
| 2 | 2 |
| 3 | 3 |
| 4 | 3.5 |
| 5 | 4 |
With all of this being said, if your company has a match and the plan is not completely horrible you should at least get the company match. Otherwise, it is free money that you are leaving on the table. Now, whether or not you should put in a higher percentage is dependent on other factors (see below).
Investment Options
While the employer match is important when making decisions about your 401(k) another important aspect is the investment options that you have available in the plan. This is something you can look at and review before you start investing in your companies 401(k). It is important to make sure that you have enough options to chose from. The plan should have a range of stocks and bonds across different markets. Another important aspect is to make sure you have ETF
Watch those Fees
One of our principles when investing is to ”Keep Fees low”. Our fee ceiling (which probably came about from watching the John Oliver video below) is 1% in fees. It is usually pretty easy to figure out the cost of fees within a fund. When reviewing the fund you should be able to see a “Fees” area. There you will see the expense ratio. That is the cost of having that fund. You will not see this fee when reviewing your fees for the 401(k) plan. They are baked into the totals of the asset value over time. Usually, we look for the funds that are Index or EFTs. These funds tend to have a lower expense ratio.
On top of the individual funds fees, a 401(k) plan can also contain fees. You should be able to find this when you get informational packet about the 401(k). They will send you a big document with the plan details including what funds you can invest in, information about 401(k) loans, and plan fees. Look carefully for the information about the plan fees. Unlike the expense ratios which you will get if you invest in that fund no matter what, the plan fees vary depending on how your company set up your plan. Some companies cover all the fees. In that situation (and assuming the fund choices are good) then investing as much as possible into your 401(k) may be the way to go. If the plan has a lot of fees that get close to or above 1% (before the expense fees are included), then you may want to consider opening an IRA.
Other Options (IRA)
This post was meant to discuss employer retirement plans (401(k)s) so we will not go too in-depth on IRAs but if while reading this post you decided your employer’s plan may not be a great option for you, you should consider an IRA. We will probably create a post for this down the road and if we so we will share it here. Until then, just know that IRAs are very similar to 401(k). They have a lower amount you can put into them every year ($6000 per year if you are under 50 years old). You may also might be eligible for some of the benefits like a Roth IRA depending on your income. One positive is that this plan is not connected to a company so you do not need a new one every time you leave your job. Another perk about having an IRA is that you can use any company you prefer (like Fidelity, Wealthfront, Vanguard, etc.).
Other Resources:
Last Week Tonight with John Oliver – Retirement Plans
Have any additional questions? Disagree? Contact us:
All opinions above are those of the writer and not of their employer(s). Nothing written above should be considered investment advice. These blog posts should be used for educational purposes only. This post is also not sponsored or endorsed by any company. For more information please read our Terms.
1 comment