Simply put, a 401k is a retirement savings plan sponsored by an employer as an added benefit to its employees. Any piece of financial literature will tell you that if your employer offers a 401k plan with a match, you should definitely be contributing. Organizations factor this money into the total compensation package they extend to potential employees upon hire, so if you don’t contribute, you are essentially walking away from free money. Extra money, on top of the yearly salary you already get. You don’t want to be the fool who walks away from free money, do you?
If you are ready to get rolling with your 401k contributions but do not know where to start, there are a number of basic things you need to know about your 401k:
1. Eligibility date. Depending on the terms of your employment, you will probably have to wait a period of time before enrolling in your company’s retirement plan. The amount of time you have to wait to enroll will depend on your company’s vesting schedule (see below.) On average, most companies have new hires wait anywhere from 1-3 months before allowing them to join the company retirement plan. In some start-up cultures employees are automatically 50% vested from the moment they start contributing, but in order to prevent transient workers from walking out with retirement contributions, they have to wait six months from date of hire to enroll.
As you can see, the eligibility date varies from organization to organization.
2. Matching rate. Most employers offer a 50% match on all funds up to a certain percentage of your salary, usually between 3-6%. Conversely, you may encounter a plan where you have to put in 4% to get the full match on 3% of your salary, etc.
Worried about saving up enough for retirement? A neat trick is to increase your contribution by 1% each year you work. Since the money is automatically debited from your paycheck before it is deposited into your bank account, you’ll barely notice the difference in your paychecks. Money never seen is money never missed!
3. Vesting schedule. Your employer will make regular contributions to your 401k plan, but the amount you get to keep after you leave the company will depend upon your company’s vesting schedule. The vesting schedule is the amount of the 401k you get to keep after a certain period of time, meaning you will get to keep more of the money the longer you stay with the company. Many organizations do not fully “vest” their employees until they have worked a period of three years or more.
For example: If you are on a vesting schedule where your 401k vests at a percentage of 25% each year of employment and your employer puts in 3% of your 30,000 salary each year, it would take you 4 years to become fully vested in all of the money your employer contributes on your behalf.
4. The tax benefits to 401ks are pretty awesome. In a 401k you contribute pretax dollars from your monthly salary, which lowers your taxable income.
Here is an example: if you make $3,000 a month and contribute $500 to your 401k, then only $2500 will be subject to tax. Pretty sweet, right?
There are also other additional tax benefits to a 401k. Like other retirement savings accounts, the dollars in a 401k grow tax-free, meaning if you keep it in the account until you reach retirement age, you do not have to pay taxes on the amount. A 401k also does not have an income limit!
5. You control your money. The way a 401k works is that your employer pays a custodian for the retirement accounts, but you get to control how to allocate your contributions and where to place your hard-earned cash. There are a variety of options such as target-date or money market funds. Target date funds are a favorite as they are a mixture of funds based on risk tolerance and how much longer an individual has until retirement. Millenials with nearly forty years to go until retirement would have a mix of “higher risk” funds to max out the earning potential, while the Boomer generation will have a mix of “safer” funds in order to stabilize current earnings.
If you are an investing novice you do not have to worry. In most 401k plans your money will automatically go into a default target-date fund until the time you feel comfortable allocating your resources to your own tastes.
6. You can foll over the account. One of the biggest reasons employees, especially young men and women just starting out in their careers, do not contribute to their 401k’s is because they fear what little contributions they have made in a few years’ time will get lost in rollover fees. This is simply not true. There are a myriad of options available to those changing companies: you can rollover into a Roth or traditional IRA, rollover into your new company’s 401k, keep it in the old 401k where it can grow tax-free, or take the lump sum distribution (which will have taxes and penalties taken out) and put it into your traditional savings.
Make sure when you roll over your money to make it a “trustee to trustee” transfer so you do not have to pay additional fees.
7. There are high limits. In 2013 employees can contribute a maximum of $17,500 to their retirement accounts (or up to $23,000 if you’re 50 or older.) This is a large chunk of change, and can add up to significant retirement savings over the long term.
Keep in mind if you are a super-saver that the retirement contribution maximum is different between 401ks and IRA’s. Say you’ve maxed out your 401k contribution. You can still contribute up to $5500 to a non-deductible traditional IRA.
Planning for retirement is something each individual has to master, so I hope I’ve been able to demystify 401ks a bit. The sooner individuals get the jump on educating themselves on their retirement savings options, and the sooner individuals start saving for retirement, the more money they will have for “the good life” later on.