A 401(k) can be a great vehicle for retirement savings. So it’s important to understand how to set one up and how they work. It’s also important to make sure you’re eligible for your workplace’s 401(k) and have a Plan B if not so you are still able to save for your future.
Why 401(k) accounts?
A 401(k) is a very common type of employer-sponsored retirement plan that’s available to all employees who meet certain criteria. The criteria are the employee must be 21 or older and have completed at least one year of service with the employer, usually defined as 1,000 work hours in a plan year. Some employers allow new employees to join right away, even if they haven’t met these criteria yet.
In 2020, you’re allowed to contribute up to $19,500 to a 401(k) or up to $26,000 if you’re 50 or older. These limits are higher than what you find with IRAs, and they enable you to set aside a fairly large sum on an annual basis.
Most 401(k)s are tax-deferred, so your contributions reduce your taxable income each year. You must pay taxes on the distributions you receive in retirement, but you may be in a lower tax bracket by then, in which case you would save money. Some employers also offer Roth 401(k)s. You pay taxes on contributions to these accounts now, but distributions in retirement are tax-free.
Some employers also match a portion of their employees’ 401(k) contributions. This can make saving for retirement easier since it’s like your employer is giving you free money for your retirement. Each company has its own rules about matching, so consult with your HR department to learn how yours works.
How do you open a 401(k)?
Do the following to open your 401(k):
- Figure out if you’re eligible. Check with your HR department to see if you can sign up. Ask if you can sign up right away or if you must wait.
- Find out if you have to do anything to enroll. Some employers automatically enroll eligible employees in the plan but sometimes you must initiate the process. regardless, you will need to fill out the appropriate paperwork to enroll.
- Decide how much money you plan to contribute. This number will be based on your estimate of how much you need to save monthly to retire comfortably. You can usually choose between contributing a set dollar amount and contributing a percentage of each paycheck. Some employers require you to contribute a specific percentage to be eligible for the employer match so many use this to help judge how much to contribute.
- Choose appropriate investment options for your contributions. Focus on finding a low-fee option, like index funds and ETFs. Make sure you keep your money diversified between stocks and bonds and among many sectors to better shield you from significant loss. Investment advice can be found through a simple Google search and standard advice will suggest riskier investments in your younger years, allowing the potential for explosive growth and if you lose money, well then at least you have time to recover. These investments should be moved into safer options as you get older so to secure the value of your savings.
Ask HR about enrolling in your 401(k)
If you’re interested in opening a 401(k), talk with your employer to learn about how your company’s plan works. Some employers automatically enroll employees and withhold a default amount of their paychecks, which you can change yourself at any time. You can also opt to stop contributing to the plan if you’re not interested in doing so right now. But if you’re reading this, my guess is that you want to opt-in.
Some companies require participants to declare their desire to participate in the 401(k). You’ll have to fill out paperwork saying that you’d like to contribute to the plan and how much money you’d like to set aside initially. You can always change this later.
When you sign up you’ll also need to choose your beneficiary. This is the person you’d like to inherit your 401(k) if you die. Usually, you choose a primary beneficiary and a secondary, or contingent, a beneficiary who will inherit the 401(k) if the primary beneficiary is deceased or doesn’t want the money.
What if I don’t have access to a 401(k)?
If you don’t work for a company that offers a 401(k), you can save for retirement using one or more of these other accounts:
- 403(b): A 403(b) is similar to a 401(k), but it’s available only to public school employees, select ministers, and employees of tax-exempt organizations.
- SIMPLE IRA: A SIMPLE IRA is designed for self-employed individuals and small business owners. It offers fairly high contribution limits and has mandatory contribution requirements for employers.
- SEP IRA: A SEP IRA is available to self-employed individuals with or without employees. Contribution limits depend in part on annual income.
- Solo 401(k): A solo 401(k) is simply a 401(k) that a self-employed person can open for themselves. Contribution limits are higher than for traditional 401(k)s because you can make contributions as both employee and employer.
- IRA: Anyone can open and contribute to an IRA if they’re earning income throughout the year, but these accounts have more restricted contribution limits.
How to maintain your 401(k)
While you shouldn’t worry about your 401(k) daily (or even weekly), you must regularly revisit it to determine if you need to make any changes to your contribution amount or to your asset allocation. Check-in at least once or twice per year or following any major life event that could affect your finances or retirement plans such as if you get married or have a child.
Look at how your investments are performing. Small losses here and there are to be expected, especially if you have a lot of your money invested in riskier assets like stocks. But, if you’re routinely losing money, that’s a sign something needs to change. You may also consider moving some of your money around if it’s underperforming major market benchmark indexes, like the Dow Jones Industrial Average and the S&P 500. Switching to an affordable index fund that tracks these benchmarks may provide better, more predictable returns.