So You’ve Got a 401(k) and Don’t Know What to Do With It

If your new job offers a 401(k) plan, and you’ve never had one before, you may have a few questions. You may know you should invest in a 401(k) thanks to all the potential benefits, but knowing you should do something and knowing how to do it are two different things.

401(k) plans 101

A 401(k) plan offers employees a special retirement savings account that comes with tax advantages that a regular brokerage account doesn’t offer. The money contributed to your 401(k) account will come straight from your paycheck, and your employer will deposit it on your behalf. Contributions in 2021 are limited to $19,500 or 100% of your salary, whichever is less.

A post-it note with 401k written above a question mark. It lays on a pile of $100 bills.

Image source: Getty Images.

A traditional 401(k) plan allows pre-tax contributions. That means you won’t pay any income tax on the amount you contribute to your 401(k). You’ll only pay taxes when you withdraw funds from your account in retirement. Some plans also offer a Roth account option. With a Roth account, you’ll still owe taxes on the contribution, but you’ll be able to withdraw that money and its earnings tax-free.

Additionally, your employer might offer a matching contribution based on your salary and contribution amount. Some employers institute a vesting period for those matching contributions, which requires employees to stay with the employer for a certain period of time before they own the matching contribution. You’ll always have a claim to your own contributions.

Once the money is in the account, you can invest the funds. Most 401(k) plans have a limited set of mutual funds and ETFs to choose from, including low-cost index funds, which will likely be your best option. You may also choose a target-date fund, which automatically adjusts the asset allocation in your portfolio based on how close you are to retirement age.

Make sure you understand what you’re investing in and the expense ratios associated with those funds. Some plans may also offer a self-directed option, for those who want more control over their investment choices.

401(k) fees

It’s important to be mindful of the fees associated with your 401(k) plan. You may find the fees buried in the paperwork you received upon hiring. Look for administration fees, servicing fees, and investment fees.

If you work for a large company with lots of plan participants, your fees are probably reasonable. Hopefully, the total of all your fees is less than 1%. But even the most reasonable 401(k) plan fees can eat a significant chunk of your earnings.

If you find your plan comes with very high fees, you may want to consider only contributing enough to get the company match at first. You could then contribute to other retirement savings accounts like an IRA. If you still have money left over, then come back to your 401(k) for additional tax-advantaged savings.

How to get your money out

It would be unwise to put money into an account if you’re not sure how you’ll get it back out. Since a 401(k) is a retirement savings account, the IRS disincentivizes people from using the money before they reach retirement age, which it has arbitrarily set as 59 1/2 years old. You can withdraw a little earlier if you leave your employer in the year you turn 55 or later. But if you withdraw your funds too early, you may be subject to a 10% penalty on the amount you withdraw.

When you do make a withdrawal from your 401(k) account, you’ll have to pay ordinary income tax. If you wait until retirement when you don’t have much other income, you can probably keep your taxes low. But if you don’t want to worry about taxes on your withdrawals, you can pay taxes upfront with Roth contributions if your 401(k) plan allows them. Note that employer-matching contributions always go in pre-tax, so you’ll pay taxes on withdrawals from that account.

How to get started

With those fundamentals covered, you’re in a position to decide if you want to participate in your company 401(k) — probably — and how much you want to contribute.

The first step is to enroll in the plan if your company doesn’t automatically enroll you upon hiring.

When you enroll, you’ll decide what percentage of your paycheck you’d like to contribute to your 401(k) account. If you can, contribute enough to get the full benefit of your employer’s matching contribution policy.

If you’re already enrolled and need to update your contribution percentage or whether you contribute to a traditional or Roth account, contact your HR department. They’ll provide the necessary paperwork to make sure the right amount of money goes in the right account.

You’ll also need to decide how to invest your savings by designating a default investment from the options in your 401(k) plan. You can always change how your money is invested from within the account, and since the account is tax-advantaged, there aren’t any taxes when you sell one fund to buy another.

The most important thing about saving for retirement, though, is just getting started. Don’t let the complexities of your 401(k) plan prevent you from setting up that initial contribution.

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