How to Set Up Your 401(k)
Investing can be a great way to build wealth. And for many of us, an easy way to get started is through a workplace retirement plan like a 401(k) (or 403(b) if you work for a non-profit). Here we’ll break down the ins and outs of how they work and what you need to know to get started.
Here’s what we cover in this guide
Why set up a 401(k)
Signing up
Type of account – traditional vs Roth
Deciding on your contribution
Selecting your investments
Sticking with it
Why set up a 401(k)?
A 401(k) can be a great way to start investing for two important reasons;
1) It offers a tax-advantage, which means your money has the potential to grow faster than it otherwise would in a more general taxable investment account.
2) Some employers offer a match, meaning they’ll contribute money in addition to what you contribute. Who doesn’t like free money?
Both of these reasons can make a 401(k) an attractive place to invest your money. But you do need to sign up to take advantage. Here’s what you do.
1. Get started by signing up
Signing up for your 401(k) is usually a fairly painless process. The information for how to do it should be provided to you when you start your new job. But you can also talk to someone in human resources if you need help.
Typically, you’ll be directed to an online portal where you can access your various benefits, which will include your 401(k).
We should also mention that some employers will automatically enroll you in a 401(k) plan as a default. The idea is to encourage employees to start investing sooner.
But even if your employer does do automatic enrollment, you’ll still want to take some time to review your plan. That’s because the default contribution amount might be too low and the investment selections might not be what you want (they tend choose fairly conservative investments). So you’ll still want to sign in and consider making changes to the default settings. We’ll get to those details – contribution amount and investment selection – shortly.
Also, some employers will have a waiting period before new hires are able to enroll. If that’s the case, be sure to mark your calendar and sign up as soon as you become eligible.
2. Choose the type of account you want
When you go to sign up for you 401(k), you might have a choice between a few different types of accounts. The traditional kind is called, well, a traditional 401(k) (yeah, not a particularly clever name). But nowadays some employers also offer something called a Roth 401(k). The difference basically comes down to how the tax benefit works.
• With a traditional 401(k), your taxes are deferred. This means you contribute pre-tax money directly from your paycheck to the account. And then your money is allowed to grow tax-free until you take it out in retirement. At that point though, you will have to pay income taxes on your distributions when you take them out each year.
• With a Roth 401(k), you do have to pay income taxes now. But your contributions are then allowed to grow tax-free and won’t be taxed when you take your money out.
So the decision is primarily about paying taxes now vs. paying them later, and it’s not always a straightforward decision. If you think you’ll be in a higher tax bracket when you retire, a Roth can be a good idea. If you think you’ll be in a lower tax bracket, a traditional might make more sense. At the end of the day, while you may not always know which one will absolutely maximize your savings to the fullest, they’re both good options for building long-term wealth.
And just to complicate things a little more, there are also traditional and Roth IRAs, which you would set up outside of work.
3. Decide on your contribution amount
When you set up your account, you’ll need to decide how much of your paycheck you want to contribute. And figuring out the right amount can be a little tricky. After all, you need to balance living today with saving for the future – the age old debate of personal finance. But if your employer does offer a match, that can serve as a guideline when you’re starting out.
In general, it’s a good idea to contribute at least enough to get the full employer match if you can.
The exact matching formula will vary from one employer to another. But often they’ll contribute a set percentage, between 50% and 100% of what you contribute, up to a certain amount, say 3% to 6% of your total pay. So you’ll want to know how your particular plan works.
Your match is basically like free money once it has vested.
And the vesting schedule tells you what percentage of the matched money you would keep if you left your employer at any given time (it usually takes a few years to be fully vested).
To be clear though, you would keep all of the money you personally contribute, regardless of the vesting schedule. It’s only the employer matched portion that follows the schedule.
And you don’t need to stop just because you hit the full match. You’re able to contribute up to the annual contribution limits set by the IRS, which currently stand at $20,500 for 2022 and $22,500 for 2023. These tend to increase over time, so you’ll want to keep track.
Any amount you contribute beyond the match will still benefit from the tax advantage we discussed above, so it’s worth considering.
4. Selecting your investments
It’s important to keep in mind that your 401(k) is not an investment itself – it’s just an account for holding your investments. So when you set yours up, you’ll have to decide what investments you want to hold in your account.
Typically, most 401(k) plans will offer a number of different investment funds to choose from. When you invest in funds, your money will be spread out across dozens or even hundreds of investments, reducing your risk. And these investments will range from stocks, to bonds, to cash.
As you compare your investment choices, pay attention to the management fees (or the expense ratios), which will vary from fund to fund and from one 401(k) plan to another.
Some 401(k) plans negotiate lower fees than you would get if you invested on your own in an IRA or taxable brokerage account. But some don’t. If you’re paying more than 0.5% in annual management fees, you’re probably better off sticking with lower cost index funds.
Your employer might also offer a default investment selection with something called a target date fund, which will automatically select and manage investments for you based on your age, reducing the risk as you approach retirement. While this might be a good choice for low hassle investing, these funds tend to charge higher fees.
Learn More: If you want to learn more about how to start investing, we have you covered.
5. Sticking with it
A great thing about having a 401(k) is that you’ll be making automatic contributions to your retirement savings without having to lift a finger. You may even be able to set up automatic increases for your account. So your contribution percentage will increase over time, getting you to save even more down the road. You might be surprised at how much you can actually put away.
And your 401(k) isn’t the end of the story when it comes to investing.
You could also consider setting up an IRA outside of work, which also offers a tax benefit (but obviously won’t have an employer match).
You can also open up a more general taxable investment account with a brokerage or robo-advisor. These won’t offer any tax benefits, but they offer more flexibility – you can take your money out anytime and don’t have to wait until retirement. With a 401(k), your money is tied up until retirement for the most part.
And it doesn’t necessarily need to be all one or the other. For example, you could invest in your 401(k) to get the full match, contribute some money to an IRA, and put some in a brokerage account or robo-advisor for nearer-term needs. But no matter which type of accounts you choose, you’ll want to periodically review your investments to make sure you’re still on the right track and your investment choices makes sense.
Summary
Setting up your 401(k) can be a great way to start investing because your contributions are automated, it offers a tax benefit, and your employer may even match a portion of your contributions.
The sooner you sign up and get started, the faster your investments will grow. And the more confident you can feel about retiring comfortably when the time comes. So what are you waiting for? Go sign up for that 401(k)!
Want more?
Rolling over a 401(k) to an IRA
Brokerage accounts and robo-advisors
