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In the complicated world of employee benefits, the 401(k) plan is one point of constant confusion; whether you contribute to one right now or you’re thinking about starting to save for retirement, this quick guide will help to answer your questions. No matter what age you are, it’s never too early (or late!) to start planning for your future or to re-evaluate your finances, and the best way forward is to arm yourself with information! Without further ado, we’ll start with the basics…
What’s a 401(k) plan & Why do I care?
A 401(k) plan is a retirement savings account sponsored by your employer, and contributed to by the employee (that’s you). In layman’s terms, it’s the modern-day answer to what used to be a “pension” plan, but as those have gone away over the years, the 401(k) has taken its place as a means to save for retirement.
What this means for you is that there is a tax-qualified plan offered by your employer that can help you save for your future – and you should absolutely take advantage of it. There are a multitude of benefits to participating in a 401(k) plan, the first being that it’s an automated way to save money for retirement; the funds are taken directly out of your paycheck, so it’s money you never see and won’t miss. Automating your savings is a simple and effective way to get ahead of the game financially, and prevents you from spending that money before you can save any of it.
Contributions & Matching
Now that we know what a 401(k) plan is, how do you decide how much money to direct to it? In 2017, the maximum contribution (pre-tax) is $18,000, but most plans are based off a percentage of your salary for contributions. If you make $50k/year and you decide to contribute 5% of your salary to your 401(k), that’s an annual contribution of $2,500. Most experts recommend saving anywhere from 10-20% of your income for retirement, but this really comes down to a) what you can afford and b) the lifestyle you want to maintain during retirement. Do your research and find out how much you need to contribute to live comfortably and within your means.
In addition to employee contributions, most employers offer a “matching” program, meaning that they will also contribute to your retirement as well. While some employers will match up to a certain percentage of your salary, others will match it dollar for dollar, so be sure to ask your HR department what the plan entails. My #1 401(k) rule is this: ALWAYS max out your employer match! If you don’t, you’re leaving free money on the table.
In the scenario above, if you’re contributing 5% of your $50k salary to your 401(k), you’ve contributed $2,500 over the course of the year. If your employer matches 1%, that’s an extra $500, or $3,000 total. If they match at 3% that’s an extra $1,500, or $4,000 total. If they match your contribution dollar for dollar, you’ve just doubled your 401(k) to $5,000 for the year, without paying anything extra!
Now add in the interest your money is making, and you can start to see how this grows exponentially. Taking advantage of your employer’s matching program is an easy way to pad your retirement savings without paying anything additional. Did you also know that you can change your contributions at any time? If you decide to save more (or less, if the need arises), you can change your contribution online or through your HR department, depending how your plan is set up. Now that we’ve covered contributions & the benefits of employer matching, let’s talk about vesting.
What is “Vesting”?
Vesting is easily the most misunderstood part of a 401(k) plan, but one of the simplest to track once you grasp the concept. In the above scenario where your employer is matching your contributions, many employers also opt to retain a portion of this money should you leave the company after a short period of time. This creates an incentive for the employee to make a long-term commitment to the company, discourages turn-over, and rewards employees that have been with the company for a longer period of time.
Each employer plan differs slightly, but let’s go with a 4-year vesting plan to demonstrate this concept. Using the 5% contribution with a $50k salary scenario, let’s pretend that your employer does a dollar for dollar match. After one year of employment with the company, you would be 25% “vested”, or you could take 25% of your employer’s contribution with you should you leave. If you stayed for 2 years, you would be 50% vested, and at 3 years you would be 75% vested. After 4 years at the company, you would be considered “fully vested”, and be allowed to take 100% of their contribution with you when you leave.
The table below shows this scenario and the implications of leaving prior to being fully vested (without the interest you’re earning on this money, which you shouldn’t forget about).
It’s easy to see how they’ve created an incentive for staying for a longer period of time; if you leave your job after only a year, you’re keeping a fraction of what you would if you had stuck around. Knowing how your vesting plan works is key to making well-informed financial decisions when it comes to your career; asking about employer match and vesting plans prior to accepting a job shows that you’re prepared, and lets you see early on whether their benefits are as robust as they claim.
Now that we’ve covered vesting, contributions, and matching, let’s talk about how all that money is making interest. Within your plan are a variety of funds that you can allocate your money to; these funds vary plan by plan, and can seem intimidating at first glance, but once you know the basics you can allocate your money like a pro.
The general rule of thumb for investing is to focus on growth and take bigger risks when you’re younger & have more time to save, and to start focusing on stability as you grow older and approach retirement. For that reason, there are a variety of funds that you can choose from that have varying levels of risk and yield built in. If you choose a riskier fund, you could see higher interest rates, or potentially lose money; with a more stable fund, you’re more likely to see low, steady interest rates.
Because most people aren’t experts in investing, 401(k) plans now have what’s called “Target Date” funds that allow you to choose a fund based on your approximate retirement date. For example, if you’re 25 and plan to retire at 62, that leaves you 37 years until retirement. Add that to the current year, and you should choose the closest fund of 2055 (they typically go by 5 year increments). This fund has been set up by professionals to allocate your money according to how much time you have left before retirement, and is generally a safe bet if you don’t have a ton of experience investing.
If you’re interested in learning more about the various funds, you can see detail on how each fund has performed over time; you can also reach out to your HR representative for any specific questions, and they can put you in touch with a plan coordinator if they don’t have the answer. Asking questions is key to making well-informed financial decisions, so I encourage anyone reading this to investigate further to know their options!
Roth vs. Traditional 401(k)
While a traditional 401(k) plan is pre-tax, meaning you don’t pay taxes on the money you contribute to your plan, a Roth 401(k) allows you to pay taxes up front on your contribution. Why do I say “allow”, as if paying taxes is a good thing? That’s because any contributions that are pre-tax will be subject to taxes at the time you withdraw that money – when you reach retirement age – and those taxes could far outweigh the taxes you’d pay on that money now.
Making contributions to a Roth 401(k) means that you’re paying taxes now so that the money you take out later (and the interest that money earned over several decades) is not subject to taxes at that time. This is hard to think about in your 20’s and 30’s, but paying taxes upfront to avoid paying a lot more down the road is one way to take advantage of your plan. I personally contribute equal amounts right now to my Traditional & Roth 401(k) options, but I plan to focus more heavily on the Roth plan in the coming years. Make an educated decision about where your money is going and direct it to one or both of these plans – most 401(k) plans allow you to make these changes online, but you can always ask HR how to direct your money if they require a form.
Knowing where your money is going is crucial to making well-informed financial decisions, and saving for retirement is no exception. Becoming an expert on your 401(k) isn’t hard but it is key to planning for your future, so I encourage you all to take some time this week to research your employer’s plan and how you can best take advantage of the various options. Now that you’re a 401(k) expert, what will you commit to contribute? Head to the comments section below to add your two cents!