Enrolling in your company’s 401(k) plan doesn’t have to be intimidating.
First and foremost: ask questions at work and read the materials given to you. (There are no stupid questions…but if you’re questioning whether to participate, GO TO START: “Do not pass go. Do not collect $200.”) Here are some things to think about when you are ready to sign up and move that account in the right direction. Oh, and our “friends” at the IRS have provided a great chart comparing different types of retirement accounts that you can find here.
1. Is there automatic enrollment or do you have to affirmatively opt in?
Some plans will automatically enroll you by default, and others require you to sign up on your own when you become eligible. It is important to find out how enrollment works with your employer’s plan.
2. If there is automatic enrollment, what is the default savings rate?
- With automatic enrollment, there would typically be a pre-set savings rate (the percent of your salary that you contribute to your 401(k) with each paycheck) to get you started in the plan.
- Plans with automatic enrollment often select 3% as the default savings rate, but there are no set rules.
- If you have been automatically enrolled, you should find out what savings rate has been set up for you and decide whether you want to increase or decrease that rate.
- You should also find out whether your plan has an automatic escalation feature, in which the savings rate is automatically increased by a set percentage (e.g., 1%) each year.
- If there is no automatic escalation, you should still consider aiming to increase your contribution rate by small amounts over time if you can (e.g., 1% per year —or portion of a year if your employer allows that), so that you can build up your savings slowly without noticing the change (too much).
3. If there is automatic enrollment, what is the default investment option?
- If you were automatically enrolled, find out what you are invested in.
- You also need to decide if you want to keep that choice in place or switch to something with a different risk/reward parameter.
4. Find out if the employer matches a percentage of your contributions, and, if so, what percent is matched and under what terms.
Many employers will match your 401(k) contributions dollar-for-dollar up to a certain percentage of your salary. However, after a certain threshold, they may only match a portion of this.
Let’s say the company matches 1-to-1 (i.e. 100%) up to 3% of salary and 50% for the next 2%. This is how the economics work out if your salary is $100,000 a year (just to use round numbers):
- Your 5% goes in for your 401(k), so you have now contributed $5,000 to your retirement;
- Your employer matches up to 3% (they have basically given you $3,000 for free); and
- For the remaining 2% match (at 50%), they are essentially giving you $1,000.
- In this example, you now have $4,000 dollars more than if you opened an IRA independently. This is more or less free money IF you participate in this retirement plan and contribute enough for the match. (Plus, you’re contributing $9,000 a year, which is a pretty sum if you look at how compounding takes very little to make you a millionaire.) You’re leaving money on the table if you don’t take advantage of this.
It’s important to understand the terms of the match and to try (VERY HARD) to contribute up to the full match amount. If you contribute less than the maximum match percentage, you are leaving “free money” on the table. With a matching program, your employer is, in essence, offering to help fund your retirement account.
This is an employee benefit that you should try to take full advantage of by contributing the maximum amount that you need to receive the maximum match amount.
5. How much should you contribute to your 401(k)?
This is a personal decision based upon many factors unique to your own financial situation.
There are IRS contribution limits based on age and type of account. Furthermore, your employer can also impose limits on the percentage of your salary that you can contribute, even if those limits are lower than the IRS limits. Some employers may also impose a minimum to participate.
The amount you decide to contribute will also be affected by how early you start saving for retirement. (The later you begin, the more you will need to save each month to try to reach your retirement goals.)
As noted above, you should try VERY HARD to at least contribute enough to qualify for the full employer match, if one is offered.
If you can’t contribute enough to qualify for the full match right away, you can consider increasing your contribution amount over time (in accordance with the plan’s rules) to try to reach that maximum match amount.
Some people think you should aim to save at least 10-20% of your gross income for retirement, including the amount you are contributing through any 401(k) plan plus any employer match.
If you start with a lower percentage, you might want to try to increase the percentage incrementally each year or portion of a year (as allowed by the plan). Increasing your investment amount in small increments means you may not feel the pinch to your bank account.
6. What types of investment choices are offered?
The number of investment choices offered to employees varies among plans, but many offer around ten or more. Sometimes the choices are just mutual funds, and sometimes there are other alternatives, including company stock, individual stocks and bonds, and variable annuities (a hybrid insurance product).
Although fund offerings will vary among plans, the selection might include:
These are funds with a target date tied to when you think you will retire. Target-date funds automatically decrease the percentage of funds allocated to stocks and increase the percentage allocated to bonds as the retirement date gets closer (i.e., a higher percentage in bonds as a person gets older). So, for example, if you are 30 today and you think you will retire when you are 65, you could look at a target date 2050 or 2055 fund. (The dates are typically every five years.)
These are passively-managed funds that track and mirror a particular index, such as the S&P 500.
Many people sing the praises of “plain vanilla” low-cost index funds that track the total market. The rationale is that it’s hard to try to beat the market. With an index fund that tracks the market, you can in essence “be” the market.
Index funds provide you with broad exposure to different markets at a lower fee.
Other funds such as stock funds, bond funds, or hybrid/blended funds (offering both stocks and bonds).
Stock funds may include:
- large-cap, mid-cap, or small-cap stocks (“cap” refers to capitalization, which is just the number of shares outstanding times the current market price, i.e. the “value” of the companies)
- domestic or international stock
- emerging markets (these are much higher risk/higher reward)
Money Market Funds:
These are FDIC-insured mutual funds that would typically pay slightly higher interest than a savings account but would provide no opportunity for market growth. These are usually seen as low risk/low reward.
Specialized Stocks & ETFs:
Some plans may also include alternatives such as natural resources and real estate.
Some people would suggest limiting investments in these to lower percentages, if at all, but again there is no right answer that works for everyone.
7. How do you decide what to invest in?
Everyone’s financial situation is different so there is no one-size-fits-all answer. Deciding what to invest in involves considering your risk tolerance, the amount of time you have until retirement, the composition and amount of other retirement assets you may have, and other factors. See here for a discussion of these and some of the other relevant issues.
You should get a sense of your own personal risk tolerance before you select your investments. (For more specifics on risk tolerance, see here.)
As a general rule, stocks are higher risk and higher reward, and bonds are lower risk and lower reward. However, there are exceptions, of course, based on many conditions including changes in the markets. Usually, people in their 20s and 30s may be able to take on more risk with their investments, because they have decades to recover from any downturn (and there will likely always be a downturn). What is important, though, is to know yourself and your own personal situation and to invest according to your own risk tolerance.
Some people apply certain rules of thumb to determine a stock-to-bond allocation based on age:
- Deduct your age from 100, and that is the percentage you should be invested in stocks, with the balance in bonds (e.g., if you are 30 years old, under this approach, a target asset allocation would be 70% stock:30% bond).
- Arguing that our retirement years will be longer than they used to be, due to greater longevity, some people suggest deducting your age from 110 or 120, and that is the percentage you should be invested in stocks, with the balance in bonds.
You have to know yourself, your risk tolerance, and your long-term goals, and decide this for yourself.
8. What about diversification?
Diversification means investing in different types of securities, sectors, asset classes, markets, large-cap vs. mid-cap vs. small cap, geopolitical area (domestic vs. international), etc., so that any large negative swing in one category won’t have as large an impact on your total portfolio.
Although there are exceptions, many people advise against investing too heavily in your company’s stock as part of a 401(k) plan, if offered as an investment option. The reason for this is diversification. Your income is already fully dependent upon the company. If you also invest a significant portion of your 401(k) assets in the company, you are not fully diversified if some negative event were to happen to the company.
Keep in mind that some plans allow the company to require that matching funds be invested in company stock. (Other plans let you decide how to invest matched funds.) Find out what the terms are under your employer’s plan.
9. What are the fees that will be charged?
Over time, fees can eat into your returns and make a large dent in your portfolio. Therefore, it is important to consider the fees (expense ratios) of any mutual funds or ETFs you may be looking into.
- Expense ratios are expressed as a percentage of the total amount invested.
As a general rule, actively-managed mutual funds would typically have higher fees than passively-managed funds such as index funds. ETFs typically have lower fees than mutual funds.
10. Does your employer offer both a traditional 401(k) and a Roth 401(k)?
A Roth 401(k) is similar to a Roth IRA, in that the money you contribute is after-tax money, not pre-tax money (i.e., you cannot deduct the amount of your contribution in the year you contribute). If you’re up for a snooze, see here and here.
The benefit of a Roth 401(k) is that your earnings grow tax-free so that there will be no tax due when you withdraw the money upon reaching retirement age (as long as you are at least 59½ years old, and you had your account for at least five years). With a traditional 401(k), you pay taxes upon distributions when you reach retirement age.
If your employer offers both types of 401(k) plans, you should decide if you want to pay the tax now or pay the tax later when you are of retirement age. Keep in mind that tax-free earnings cover all of those years of compounding, so there is an advantage to selecting a Roth option (all other things being equal).
- If you think your tax bracket will be higher when you are of retirement age than now, then the Roth could be a better choice for you.
- If you want to save and take home as much as possible today, then the traditional 401(k) may be better for your needs.
You are allowed to have both a traditional and a Roth 401(k) (if both are offered), as long as your total contributions do not exceed the annual limit.
- Some people may choose to have both types as a way to hedge against the uncertainty of not knowing what the tax rates will be in the future.
- Unlike the Roth IRA, the Roth 401(k) has no income restrictions. The Roth 401(k) may be a good option for people who want a Roth IRA but are ineligible due to the income limits.