A Guide to Your 401(k)

Why you should enroll in your 401(k) at work.

This is for everyone who has a job with a retirement plan and has no idea how it works. You might fall into two camps. One, you just got your first job with a 401(k) plan and you don’t know where to start. Two, you’ve been at a job with a 401(k) plan for some time now but the idea of enrolling intimidates you or you don’t understand the benefits.

First, what is a 401(k)? Simply put, it’s a type of employer-sponsored, tax-advantaged retirement account. If you want to start putting away money for retirement, a 401(k) is one of the better tools you have at your disposal.

So where do you even begin? I’ll cover some of the most important things you should know about workplace retirement plans and how to take advantage of them. I’m going to use the term 401(k) throughout this piece, but most of the information applies equally if you have a 403(b), 457(b) or TSP.

Why You Should Enroll in Your 401(k)

You probably want to retire someday, and that’s going to require significant savings, even after Social Security. 401(k)s are the perfect forced savings tool. Anyone can open a Roth IRA or invest in a taxable brokerage account, but when you have a 401(k) through work and contributions are automatically deducted from your paycheck, it makes it so much easier to reach your retirement goals.

401(k)s also come with significant tax benefits. Depending on what kind of accounts you have available, you can receive a tax deduction on the front end with a traditional 401(k) or enjoy tax-free growth forever with a Roth 401(k).

But one of the biggest benefits is the company match. This will look different depending on the company you work for — and some companies may not have a match at all — but if your company does offer a match, it’s free money you don’t want to pass up.

What to Learn About Your 401(k)

There are a few important pieces of information you should find out about your 401(k):

1. Find Out if You Have One

If you don’t know if you have a 401(k), go to the HR person at your job and ask.

2. When You Can Enroll

Most companies have a waiting period for enrollment. This tends to be between three and six months from the time you start but in some cases, it can be a year. Companies can make you wait as long as two years, but this is quite rare.

3. What the Match Looks Like

Here are some common matching structures:

• A 100% match on up to 3%, 4%, 5% or 6%

• A 100% match on up to 3% and a 50% match on the next 2%

You want to find out the minimum percentage you need to contribute to get the maximum match. You can contribute more if you want, but this should be priority number one.

4. The Investment Options

Ideally, your 401(k) offers index funds. If you see Vanguard funds, you’re in luck, but there are many other index fund providers as well. More on how to spot index funds later.

5. Roth v. Traditional

All companies offer a traditional (pre-tax) 401(k). Most offer a Roth (after-tax) 401(k) as well. Find out what your company offers.

Why You Can’t Leave Money on the Table

This is important. Even if you already save for retirement in a Roth IRA, a taxable brokerage account or via real estate and have no interest in using your 401(k), you should still at least contribute the minimum required to get the maximum match. If you don’t, you’re leaving free money on the table. It’s like your boss offering you a raise and then you decline it. No sane employee would do that.

Normally, the percentage you have to contribute to get the full match isn’t very high, so you’re unlikely to experience any hardship to get the match.

How to Pick Your Investments

As I alluded to before, you want to find the index funds. Vanguard is an easy tip-off that you’ve found them. Otherwise, look for funds with expense ratios of 0.25% or less and avoid expense ratios of 0.75% or more. Not everyone has this luxury, but chances are you do.

As far as asset allocation goes, the wisest choice would be to pick a U.S. stock market fund and an international stock market fund. If you want bonds, pick a U.S. bond market fund. This will help you diversify your investments.

If this still intimidates you, almost all 401(k) plans nowadays include a default investment option of target-date funds. These are all-in-one diversified funds with an allocation based on your age. As you get older, the fund will become more conservative. I’m not a huge fan of target-date funds, but they’re better than nothing until you feel like you can pick your investments more confidently.

Traditional v. Roth

Workers are increasingly faced with two options for 401(k)s: traditional or Roth. If you have a traditional 401(k), you receive a tax deduction for contributions. For example: Let’s say you earn $50,000 a year and you contribute $10,000 to your 401(k). Only $40,000 will be taxable. When you retire, the money in your 401(k) will be taxed as you withdraw it.

A Roth 401(k) gives you no deduction, but you have the benefit of enjoying completely tax-free growth forever. Your investments will grow tax-free and your withdrawals in retirement will be tax-free.

When should you choose one over the other? There’s no definitive right or wrong answer as it depends on a lot of factors, but generally, if you anticipate your income in retirement being lower than it is now you should choose a traditional 401(k), and if you anticipate your income being higher in retirement, you should choose a Roth 401(k). Anticipate being the operative word because no one can predict the future.

Here’s a general rule of thumb. If you’re young and just starting your career, you probably want a Roth 401(k), as the time will come when you have a higher income than you do now. If you’re mid- or late-career with a higher income well into the six figures, you probably want to take advantage of a traditional 401(k) to protect your income from high tax rates today. Tax rates can change of course, but again, no one can predict the future.

The good news is if you’re unsure of which to choose, most 401(k) plans let you split the difference and put a little bit into both types of accounts.

What to Do With Your 401(k) When You Leave a Job

What happens to your 401(k) when you leave your job? Well, most of the time you can keep it there if you have a balance of at least $5,000. If it’s less, your company may send you the money via check, in which case you will have 60 days to deposit the money into another retirement plan or pay income taxes and a 10% penalty.

But even if you can keep it at your old employer, you may not want to for a variety of reasons. One, your investment options may not be the best. Rolling over your account to an IRA or your new employer’s plan can give you more options. Another reason is you might not want to leave 401(k)s from various former employers floating out there where they can be forgotten. Consolidating your accounts ensures everything stays together.

So when you do leave your job, the best move generally is to move it over to an IRA or a new 401(k).

Downsides to Using a 401(k)

There are a few potential downsides to using a 401(k):

1. Your Money is Locked Up

In many ways, this is a feature, not a bug. Keeping your retirement money locked up means you’re less likely to raid the account early. But you should know this before committing significant amounts of your savings that you may need for other goals before retirement.

2. Fees

Your 401(k) may have fees that other investment accounts you can open on your own don’t. For example, on top of high expense ratio mutual funds, you may have a 0.50% account administration fee. While this doesn’t seem like a lot, over time it’s a significant drag on your investment performance. Of course, you also have to factor in the company match that should make up for what you lose to fees.

3. Limited Investment Options

With an IRA, you have pretty unlimited investment options. Inside your 401(k), you may only have a handful. Want to invest in small-cap value or REITs? Your 401(k) may not have those options.

None of these are reasons you shouldn’t use your 401(k) at all, but you should still understand what you could be losing.

How to Enroll in Your 401(k)

If you have a workplace retirement plan that you aren’t participating in, contact the HR person at your company and find out how you can correct it. 401(k)s are amazing benefits, especially when they come with a company match. You don’t need to be mystified by your 401(k). It may seem complex, but your company will likely walk you through everything you need to do if you just ask.

Once you’ve enrolled and you’re automatically contributing to your plan, congratulations. You’re now investing for retirement.