A Complete Guide To 401(K)S

If you’re working and already saving for retirement or plan to start socking away money soon, educating yourself on how investing in a 401(k) plan works and how it can help you build a sizable nest egg makes good financial sense.

The 401(k) plan, formed in 1978 following a change in IRS rules, is one of the most popular types of employer-sponsored retirement plans in the U.S.

More than 55 million Americans invest in 401(k)s and these retirement plans hold $5.6 trillion in assets, according to the Investment Company Institute, citing data as of Sept. 30, 2018.

If you’re thinking about signing up for a 401(k) at work, or simply want to know more about how to take full advantage of this type of retirement savings vehicle, here’s a primer on everything you need to know.

How do 401(k) plans work?

Unlike traditional pension plans, in which the employer promises a specified monthly benefit at retirement that they fund fully, 401(k) plans are funded by contributions deducted directly from the employee’s paycheck. Many companies “match” contributions up to a certain percentage of your annual salary, which is one of many notable 401(k) benefits.

In addition, employee contributions to a traditional 401(k) plan are made with pretax dollars (which lowers your taxable income) and grow tax-deferred until withdrawn (which means all of your invested dollars are working for you in the market). Any 401(k) withdrawal that occurs before age 59 ½, however, may be subject to an additional tax and a 10 percent penalty.

Because your 401(k) contributions are automatically deducted from your paycheck and may be matched by your employer, it’s an easy way to automate saving for retirement and invest regularly.

How do I get started?

There are several things to consider as you get started on the path to saving for retirement in a 401(k) plan.

Catherine Golladay, senior VP and chief operating officer at Schwab Retirement Plan Services, suggests these steps:

• Determine what your company’s eligibility requirements are and if you’ll be automatically enrolled in the plan.
• Find out if your company offers a matching contribution and how much the employer will contribute based on how much you put in. Contribute enough to take full advantage of the match. For example, if your company matches up to 6 percent of your pay, try to save at least 6 percent of your annual salary on your own.
• Examine the plan’s investment menu options, keeping an eye on the risks and fees associated with each investment. The lower the fees the better. Some funds have lower operating expenses and fees, which means more of your money will be put to work in investments. When it comes to risk, investing in stocks or funds that invest in equities can be riskier and expose you to short-term losses — despite stocks’ history of delivering bigger returns than cash and bonds over long periods of time.
• Take advantage of any managed account service or third-party professional advice that comes with the plan.

What is the annual maximum contribution?

For 2019, the maximum contribution you can make to a 401(k) plan is $19,000, according to the IRS. Those age 50 and older can make an additional “catch-up” contribution up to $6,000.

When it comes to how much of your pay you should contribute, everyone has different financial needs in retirement, but there are some general rules you can follow.

As a starting point, contribute enough to take advantage of any matching dollars offered by your employer, says Golladay. Whether your company match is dollar-for-dollar or something smaller, such as 50 cents on the dollar, don’t pass up the match.

“Not doing so is like leaving money on the table,” she says.

After saving enough to get the full employer match, Golladay suggests paying off high-interest debt and building an emergency fund, and then going back and maximizing tax-advantaged retirement accounts.

Can I contribute 100 percent of my salary to a 401(k)?

As mentioned above, there are limits to how much an individual can contribute each year to their 401(k). For 2019, that limit is $19,000, plus another $6,000 if you are 50 or older.

How to invest your retirement savings

Most 401(k) plans have at least three investment choices, with the average plan offering between eight and 12 investment options, according to the Financial Industry Regulatory Authority. The menu could include a mix of investments, such as mutual funds, company stock and index funds, as well as stable value funds (or cash), bond funds and so-called “target date” funds, which take your age and years before retirement into account when selecting suitable investments.

Compare saving rates on Bankrate.

Fortunately, while you can pick your own funds if you’re the do-it-yourself type, you don’t have to decide how to invest completely on your own.

“Many of today’s 401(k) plans include professional investment advice, which can be key in helping the participant make 401(k) investment decisions based on their overall financial picture,” says Golladay.

One increasingly popular retirement investment option is known as a target date fund, or TDF. A TDF automatically adjusts the mix of investments over time to align with investors’ risk tolerance as they approach retirement.

But target date funds don’t fit every individual’s needs.

“While a TDF can be effective, a more tailored portfolio based on multiple data points about the investor may be the best option for some,” says Golladay.

Before you can decide how to allocate your contributions, you have to determine your risk tolerance. It’s critical to know how much volatility within your portfolio you can deal with. You want to make sure you can sleep at night if financial markets turn turbulent and asset prices fall. But keep in mind that markets historically have recovered even after brutal bear markets, or stock market declines of 20 percent or more.

If you’re in your 20s or early 30s, therefore, you can afford to be more aggressive with your investments because you have more time to recover from market slumps. As you age, however, your asset allocation should shift to more conservative investments to protect the earnings.

“Generally speaking, a younger worker will choose to allocate most of their portfolio to stocks, and over time, gradually move the balance towards more conservative bonds and other fixed income investments,” says Golladay.

Can you lose money?

“All investments come with risk, but the fear of losing money should not inhibit someone from utilizing a 401(k),” says Golladay.

While markets go up and go down, history has shown that over the long run, they move up. As measured by the Standard & Poor’s 500 stock index, over time stocks return around 10 percent annually. The S&P 500 comprises about 500 of America’s largest publicly traded companies.

Taking a long-term approach to your retirement investments is a prudent strategy.

“In times of market volatility or uncertainty, it’s important to remember that panic isn’t a strategy, especially with an investment as long-term in nature as a 401(k),” says Golladay.

How much money should I have in my 401(k) at age 30?

As a general rule, try to have at least 1x your salary saved by age 30, according to Fidelity, one of the nation’s largest 401(k) plan providers by assets.

For example, a 30-year-old earning $60,000 per year with $60,000 saved for retirement would be on track.

The amount of money a worker should have set aside for retirement moves up with age. Aim to have 3x your salary saved by age 40, 6x by age 50, 8x by age 60 and 10x by age 67, according to Fidelity.

Generally, investors should aim to save at least 15 percent of their income to hit their savings benchmarks at different ages, according to T. Rowe Price.

If you haven’t quite hit those marks, you’re not alone. Here’s how much people have saved by age:

• Age 20 to 29: $10,500
• Age 30 to 39: $38,400
• Age 40 to 49: $93,400
• Age 50 to 59: $160,000
• Age 60 to 69: $182,100
• Ages 70+: $171,400

Tools to use

Many 401(k) plans offer tools (online calculators, worksheets) for determining risk tolerance and suitable investment options, But if you’re not comfortable selecting funds or building an investment portfolio on your own, the best tool may be a competent financial planner. It may be worth hiring a planner to listen to your financial goals and evaluate your assets and earning ability to help you craft an asset allocation plan that will ensure a comfortable retirement.

Use our 401(K) calculator to estimate your savings over time.

Borrowing from your investments

If you need cash for an emergency or to pay down debt, your 401(k) plan may allow you to take out a loan and borrow up to 50% of your vested balance, but not more than $50,000. In most cases, you have to repay the money with interest within 5 years. While the interest payments go into your account (which means you are paying yourself back rather giving your money to a bank), there are downsides.

When you make a 401(k) withdrawal, that money is no longer invested in the market, and, therefore, you could miss out on gains if the asset prices continue to rise.

Also, the original contributions to the account were made with pretax dollars, but the loan payments will be made with after-tax dollars.

What happens to your 401(k) when you switch jobs?

Workers have a few different options for dealing with their old 401(k) after leaving a company.

Here are a few options, according to Golladay:

• Roll it over into an IRA, or Individual Retirement Account.
• Keep the assets in the former employer’s plan, if permitted.
• Roll it over into a new employer’s plan, if permitted.

You also may have the option of taking a cash distribution, or lump sum, but you could get hit with penalties and taxes.

Whichever path you choose, it’s important to understand the benefits and limitations of each option according to your unique financial situation, notes Golladay.