When I snagged my first job out of college I was 22 years old, I felt utterly thrilled to be sitting down to do something that felt so novel to me: finalizing my contract with an HR representative. This kind woman was helping me fill out and sign a stack of new hire paperwork, and proceeded to tell me a little bit about my 401(k) options. She let me know that I could revisit the decision at a later date, as she didn’t want to overwhelm me with too much information. Well, I did eventually revisit the option — roughly three years later. For three years, I missed out on receiving free money that my company had offered to match. I spent three consecutive years saving a lot in my personal savings account, yes, but missing out on the perks of having my tax-free money stored away where I couldn’t use it, and growing from interest, capital gains, and dividends. Safe from the shopping trips brought on by emotion, and the expensive dinners that resulted from the roller coaster of life’s stressful and euphoric moments.
In a lot of ways, I feel that I ignored the nagging feeling that resulted from me not putting away money into a 401(k). It was a task I put off and didn’t want to face, because I was frankly confused by the whole process. It didn’t feel pertinent to save for a very distant, future version of myself. The irony of the situation is that by the time I began doing more research into my 401(k) options and I realized how important they were, I had already made the decision to leave my 9-5 job to work at TFD full-time. It didn’t make sense to start contributing a portion of my monthly income when I only had two months left on the job. Instead, I doubled down on my savings to try to alleviate the sense of failure I felt from having dragged my feet over the last three years. It feels very embarrassing to admit that I have no formal 401(k) savings plan at the moment, but it’s a confession that I hope will make you evaluate your own circumstances and realize how important it is to set up a 401(k) at your company straight away.
While there are a number of different employer-sponsored retirement savings plans, I’m here to talk about just 401(k) savings plans (plans offered to employees of public or private for-profit companies). As you can gather from the story above, I am no expert , and I strongly encourage you to do your own research and speak with the HR representative at your office to review your options. I simply seek to share what I have learned from my own experience which may help illuminate gaps in knowledge for others. Below are seven things worth knowing about 401(k) savings plans that will help you gain a more comprehensive understanding.
1. What is a 401(k) savings plan?
In simple terms, a 401(k) plan is one of many defined contribution plans. One in which you contribute money toward your retirement without having to pay tax on said money — you don’t pay federal or state income taxes on your savings or their investment earnings until you withdraw the money at retirement. This is beneficial because for most people, they have less income in retirement than when working full-time and so their tax rate is generally much lower in retirement.
2. How does it work?
It’s fairly simple. You set a percentage of each paycheck you would like to have removed (i.e, you never see the money because your employer takes it out before you receive your paycheck). As CNN Money describes it:
“Your company serves as the “plan sponsor” for the 401(k), but it doesn’t have anything to do with investing the money. Instead, the plan sponsor hires another company to administer the plan and its investments. The plan administrator may be a mutual fund company (such as Fidelity, Vanguard or T. Rowe Price), a brokerage firm (such as Schwab or Merrill Lynch) or even an insurance company (such as Prudential or MetLife).”
The amount you should contribute varies depending on who you ask. Some financial advisors advocate that you save anywhere from 10%-15% of your income, but this isn’t feasible for everyone, and you have to save whatever amount your budget can accommodate (while making sure you aren’t being lazy about it).
3. Your company might match the money you lay out.
TwoCents explains this arrangement in excellent terms saying:
Let’s say you make $50,000 a year and your employer says he will match you $1 for every dollar you contribute to your 401(k) on the first 5% of your salary you invest. You decide to save 10% of your salary in your 401(k). That’s $5,000 that YOU contribute out of your pocket to your 401(k).
Now here comes your employer’s contribution. He’ll match your contribution dollar for dollar up to 5% of your salary. That means your employer will contribute $2,500 to your account. That’s $2,500 of FREE money and a 50% return on your initial investment of $5,000.
Although your employer caps off its contribution, make sure to take advantage of the essentially free money that they do offer by matching. Start contributing now! Whenever I think about the money I missed out on receiving because I was too lazy to do my research, I feel like kicking myself. Learn from my mistake and don’t let the opportunity to receive free money from your employer pass you by.
4. What happens once the money is in the 401(k) account?
There was once a time when I imagined that money set aside in a 401(k) plan went into some giant golden pot where it would simply accrue interest, and make more money. I’ve since learned that that notion is false – the money you have set aside needs to be invested in something, and it is your job to decide how to allocate those savings. Don’t let this choice feel daunting, though. If you do your research and ask the right questions, you’ll understand what each option offers and how they can be combined to help you achieve your investments goals. Millennial investors should start saving early and allocate most of their portfolio to stocks, which offer the opportunity for long-term growth. As TIME Money explains it:
When investing for a long-term goal like retirement, you typically want to invest mostly in stocks, which have the best chance to generate returns that outpace inflation. Adding some bonds or cash to your mix can help reduce the volatility of your overall portfolio.
5. Am I eligible straight away?
Each employer is different. Some employers have a waiting period before you can start participating in their 401(k) plan, and this can vary from a month to a year-long waiting period. My previous employer allowed employees to begin making contributions as soon as they were hired. However, some employers may require you to wait until you’ve passed a period of time before they start matching contributions to your account. Again, it’s always helpful to check your company’s benefits enrollment materials or speak with an HR representative.
6. Are there limits to how much I can contribute?
Yes. For 2015, the maximum amount of money an individual under 50 years of age is allowed to contribute is $18,000. I realize that a majority of us are likely nowhere near reaching that number, but the point is that we should be aiming to contribute as much as possible, as early as possible.
7. What happens to my 401(k) if I leave my job?
There are a few courses of action one can take regarding their 401(k) if they are leaving their job. TIME Money explains the following possibilities:
- Move the money into an IRA rollover account at a mutual fund company or discount brokerage. This is typically the smartest move. Your money continues to grow tax-deferred, but you are no longer limited to the investment choices within your old plan. The fund company or brokerage that will administer your new account can provide a rollover application. Make sure you choose “direct rollover” as the method for moving the money from your old employer into your new rollover IRA so you don’t get hit with taxes.
- Move the money into your new employer’s plan. Check with your new company: Not all defined contribution plans allow this move.
- Leave the money right where it is. Your former employer may not allow you to stay in the plan if your account balance is less than $5,000, however. And because you’re no longer an employee, you may miss out on important information about plan changes and investment options.
- Cash out and take the money as a distribution. This is a bad idea, because your money will no longer have the advantages of tax-deferred growth. Worse, you’ll pay income tax on the entire amount of the distribution, and you’ll be hit with a 10% early withdrawal penalty if you aren’t yet 59 ½ years old.
The last option is definitely NOT advisable, but a possibility in theory.
Below is a list of additional resources that you should read to further educate yourself before making this important choice. Good savings!
- What Is a 401(k) Plan.
- 5 Things You Should Do Before Opening a 401(k)
- 7 Must-Do’s When Opening a 401(k).
- 3 Ways To Maximize Your 401(k) Plan.
- 6 Ways To Maximize The Value Of Your 401(k).