Budgeting & Saving

What is a 401(k)?

If you're feeling a little bit behind the curve on saving for retirement, you've got plenty of company. The non-partisan Employee Benefit Research Institute (EBRI) reports that less than one in five workers feels very confident they will be able to live comfortably in retirement.

Deep breath time. There's a good chance your job offers a smart way to boost your retirement confidence. About 55 million workers have a 401(k) account and collectively we've got about $5 trillion saved up in our 401(k)s.

A 401(k) is a retirement savings plan offered by employers that helps workers set aside money today for their retirement. It's loaded with incentives to help you save, including tax breaks, and in many cases, a matching contribution from your company.

Now it's true that a defining feature of a 401(k) is that you are in charge of your personal account, with full responsibility for deciding how much to save and how to invest. The good news is that you really only need to get up to speed on a few core 401(k) principles to master the art of retirement saving.

401(k): Getting Started Guide

Many 401(k) retirement plans automatically enroll new hires. (You can always opt out.) If you're not currently enrolled, ping your HR team and ask what you need to do. Sometimes you need to wait a few months or longer before you can participate in the plan.

One of the best features of a 401(k) is that your contribution is automatically deposited into your individual 401(k) account each pay period.

In 2017, employees under 50 years old are allowed to save up to $18,000 in a 401(k). Older workers are eligible for a catch-up contribution that pushes their annual limit to $24,000. Those limits are adjusted periodically to keep pace with inflation.

Many employers will also match your contribution. Every plan has its own match formula. One common formula is a 50% matching contribution up to 6% of your salary. Translation: If you contribute at least 6% of your salary into your 401(k) account, your employer will match 50% of that, which works out to another 3% landing in your account. Bonus!

The money you contribute to your 401(k) is 100% yours, forever. The money your employer contributes as a match will often "vest" over a few years, which is lingo for when it becomes 100% yours.

Key Considerations:

  • Push Yourself to Save Up. As a general guideline, saving 10% to 15% of your salary in a 401(k) is considered a solid strategy for building retirement security. Yet when many plans automatically enroll new employees in the 401(k) they often set the salary contribution rate at just 3%. Even if you are eligible for a company matching contribution, that's still going to leave you well shy of 10% to 15%.
  • Explore the Roth Option. Many plans now offer two flavors of 401(k)s: A Traditional 401(k) and a Roth 401(k). It's up to you to choose which one to save in. You can also toggle between the two from year to year.

While your money is invested in either account you owe no tax. The only difference in these plans is when the tax man takes his share.

With a Traditional 401(k), you get an upfront tax break. Your contributions reduce your taxable income. For instance, if your salary is $75,000 and you contribute $7,500 to a Traditional 401(k) your taxable income for the year is $67,500 ($75,000-$7,500.) Then, in retirement, you will be required to take withdrawals from a Traditional 401(k) and every penny you withdraw will be taxed as ordinary income.

With a Roth 401(k) there's no upfront tax break. What you contribute this year will not reduce your taxable income. But in retirement, any money you withdraw from a Roth 401(k) will be 100% tax free. If your plan offers a Roth 401(k), it likely has information to help you weigh the value of taking your tax break today v. saving it for retirement. As part of upcoming tax reform negotiations, the Trump administration is said to be considering a controversial proposal that would remove the Traditional 401(k) as an option for new contributions, effectively ending the ability to take the tax break upfront. But for now, you have a choice between Traditional and Roth 401(k).

Invest for the Long-Term

The next step is figuring out how you want to invest your money, what the wonks often refer to as asset allocation.

You are typically limited to the lineup of mutual funds offered by your plan. (Some plans also offer company stock.) A mutual fund gives you instant access to a key of successful investing: diversification. Each mutual fund typically owns dozens of stocks or bonds. Some own hundreds of individual securities.

Most plans offer a variety of different types of funds you can choose from. It may include funds that invest in stocks and funds that invest in bonds. There are also funds that own a mix of stocks and bonds. You will also likely have the option to invest in funds that focus on U.S. stocks and bonds, as well as funds that invest in international stocks and bonds. If you see the word global in a fund name that means it owns a mix of U.S. and international investments.

The big challenge is deciding what sort of stock-bond-cash mix you want. Over the long-term (decades) stocks have historically delivered the highest inflation-beating gains. But over the short-term, you will run into periods where stocks can also lose plenty. Bonds, typically offer lower returns than stocks, but they also aren't prone to the dramatic price swings stocks can encounter.

Your 401(k) plan likely has online tools and articles to help you wade through the allocation decisions.

Key consideration:

  • Got Allocation Anxiety? Check Out the TDF. If the mention of asset allocation set off some sweating-or boredom, relax. Chances are, your 401(k) offers an easy way to build a smartly diversified retirement portfolio: a Target Date Fund (TDF), also often referred to as a Target Date Retirement fund, is a one-and-done solution that owns a mix of stock and bond funds investment pros deem appropriate based on when you expect to retire. Generally, the further off your retirement date, the more a TDF will keep invested in stocks. As you age, the TDF will automatically shift to own more bonds.

Stay Focused on Retirement

Some features of 401(k)s can make it all too easy to do damage to your retirement security.

401(k) Loans: Most 401(k) plans allow participants to borrow money from their retirement account. Typically, you need to repay the loan (to yourself) within five years. One potential cost of taking a loan is that while you are repaying the money you likely aren't also continuing to make additional fresh contributions to your account.

Moreover, if you leave a job with a loan on the books, you typically have a short 60 days to get the loan paid off. Miss that deadline and your loan becomes a withdrawal. If you left a job before the age of 55 you will owe a 10% early withdrawal penalty, and if your loan came from a Traditional 401(k) account you will owe income tax on the withdrawal.

401(k) Early Withdrawals: As a general rule, any time you take money out of a 401(k) before the age of 59 ½ you may be hit with the 10% early withdrawal penalty. (If you are 55 and have left a job, a withdrawal will not trigger the 10% penalty.) And there can be an income tax as well. Perhaps the biggest cost is that money you pull out of your plan ahead of schedule is money you won't have to tap when you are retired.

Cash-Outs: When you leave a job, you have a few options on what to do with your 401(k) account. You can likely leave it at your old employer if your account balance is at least $5,000. Or your new employer may allow you to move the money over to your new 401(k). You can also move the account into an Individual Retirement Account (IRA) at a discount brokerage or fund company. That's what's called an IRA Rollover.

Another option is to cash out your money. While certainly tempting, it can cause a big hit to your retirement security. For example, if you have $10,000 in a traditional 401(k) and cash it out today, you will likely net just $6,500 or so after paying income tax, and the 10% early withdrawal penalty. If instead, you leave the $10,000 growing for another 25 years earning an annualized 5%, it could be worth around $34,000. That's sure to boost your retirement confidence.

Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.

This article was originally published on September 6, 2017, and has been updated.

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