A Guide to Set Up Your 401(K)
A 401(k) is an employer-sponsored retirement plan that enables employees to save for retirement with tax advantages. This plan helps workers accumulate savings more efficiently for their future. Most 401(k) plans become available either when employees start a new job or after a specified waiting period, such as 30 days from the employee’s start date. Enrollment procedures can vary by company: some employers automatically enroll their staff, while others require employees to sign up on their own.
Here’s a guide on how to set up your 401(k) and important considerations to keep in mind.
1. Get enrolled
Some employers automatically enroll their employees in a 401(k) plan at a set percentage of their salary, while others require employees to enroll themselves either right away or after a waiting period.
The advantage is that you can enroll in a 401(k) at any time throughout the year, with the flexibility to adjust your contributions as needed. This allows you to increase, decrease, or pause your contributions whenever you wish.
To find out more about your 401(k) plan, check your company’s benefits platform or reach out to your human resources representative. They can provide information on whether you’ve already been enrolled or guide you through the enrollment process if you haven’t.
2. Set a contribution amount you’re comfortable with
For 2024, the maximum annual contribution limit for a 401(k) is $23,000. The percentage of your salary required to reach this limit will depend on your income.
If you’re unable to contribute the maximum amount, start with whatever you can afford. The key is to consistently contribute from each paycheck, regardless of the amount. You can always increase your contributions over time. Some 401(k) plans even offer the option to automatically increase your contribution each year.
3. Maximize your employer’s 401(k) match
When deciding how much to contribute to your 401(k), be aware that many employers offer a match on employee contributions, typically ranging from 3% to 5% of your salary. This is essentially free money, so it’s beneficial to take full advantage of it if possible.
However, some plans have a vesting period, meaning you must remain with the company for a certain number of years before you fully own the matched contributions. If you leave your job before the vesting period is complete, you may only retain a portion of the employer match. Your own contributions, however, are always fully vested and remain with you regardless of employment status.
Once you meet the vesting requirements, you will own 100% of the employer match and any future matching contributions.
4. Choose between traditional and Roth options
A 401(k) plan comes in two primary types, each with its own tax benefits: the traditional 401(k) and the Roth 401(k).
A traditional 401(k) allows you to make contributions with pre-tax dollars, reducing your taxable income for the year. Your money grows tax-deferred and is only taxed when you withdraw it during retirement.
In contrast, a Roth 401(k) involves contributing after-tax dollars, so you don’t receive an immediate tax break. However, your investments grow tax-free, and withdrawals are tax-free once you reach age 59½, provided the account has been open for at least five years.
Each type offers distinct advantages. A traditional 401(k) provides immediate tax savings by reducing your taxable income, but you’ll pay taxes on withdrawals later. A Roth 401(k) does not offer upfront tax benefits but allows for tax-free withdrawals in retirement.
You can contribute to both types of 401(k) plans, as long as your total contributions do not exceed the annual limit. This approach lets you leverage the benefits of both accounts.
5. Choose your investments wisely
While your employer provides the 401(k) plan, you are responsible for managing the account’s investments, including deciding whether to handle it yourself or delegate the management to someone else.
If you choose to manage the account yourself, you’ll select from the investment options offered by the plan and determine how to allocate your 401(k) contributions.
Most 401(k) plans offer at least three investment choices for asset allocation, though some provide many more. On average, a 401(k) plan features about 13 investment options, according to the Investment Company Institute.
Investment choices can include a variety of options such as mutual funds, company stock, index funds, stable value funds, bond funds, and “target-date” funds, which adjust the risk level of your portfolio as you approach retirement.
Some plans may also allow you to invest in additional options like individual stocks and bonds, guaranteed investment contracts, company stock, and variable annuities.
For each investment option, you can review prospectuses that provide detailed information about the fund, including performance and costs, which are essential for making informed decisions.
Historically, stock funds have generally outperformed bond funds over the long term, although they can be more volatile in the short term. Many experts recommend that investors with several decades until retirement focus on a diversified portfolio of stocks or stock funds.
To get a clearer picture of how your contributions will impact your retirement savings over time, you can use tools like Bankrate’s 401(k) calculator.
6. Take fees into consideration
Mutual funds come with investment fees that can impact your overall returns, so it’s crucial to factor these into your decision-making process. These fees are outlined in the fund’s prospectus. Typically, mutual funds charge an expense ratio, which is a fee based on the amount you have invested in the fund. However, there may be additional fees as well.
When evaluating fees, consider them in relation to the fund’s performance. Fees for stock and bond mutual funds can vary significantly, from less than 0.15 percent annually to more than 1 percent annually. For example, a fee of 0.15 percent would amount to $15 per year for every $10,000 invested, whereas a fee of 1 percent could cost $100 or more. Target-date funds and annuities generally have higher fees compared to other mutual funds. On the other hand, stock funds often provide strong long-term returns and are available at lower costs through index funds.
If you opt for professional management of your investments, you will typically incur higher fees compared to managing the account yourself or investing in a target-date fund.
In Conclusion
When setting up your 401(k), remember that retirement savings is a long-term endeavor. Consider your individual time horizon and risk tolerance when making investment choices. It’s also wise to periodically review your account after setting it up to ensure it is meeting your performance expectations.
