Signing up for your 401(k) can seem intimidating, but it’s probably not the hardest thing you’ll do this month. The most important thing for now is to get it done so you can begin accumulating savings. Then you can focus on more important things in life (and revisit your retirement plan every 6 – 12 months).
What Is a 401(k), Anyway?
401(k) plans are retirement plans that help you save for the future. They allow you to save for your future out of your earnings, and your employer might also contribute to your account. If you receive profit-sharing and matching contributions from your employer, you build up savings even faster.
401(k) plans may be able to help you manage your taxes (both today and later, in retirement). You can potentially reduce the amount of income you pay taxes on by contributing to the plan, which can make it easier to save. Some plans also allow you to save after-tax Roth money, which can possibly provide tax-free income in retirement.
There’s a lot more to know, and we’ll cover additional topics as we go.
Before You Start
You may be eager to get this done, but let’s reduce the chances of wasting your time or money.
Get details on the plan from your employer.
- You need to verify that you’re eligible to join the plan. If your employer told you you’re eligible, that’s probably good enough.
- You need to know what you’re getting into: Are loans allowed, and are there any other ways to pull money out in an emergency? Do you need to wait a certain number of years for vesting?
- Gather information on fees and expenses in your plan — but don’t let that prevent you from getting enrolled, especially if your employer matches your contributions.
- Find out how to enroll and any deadlines for enrolling.
Most of that information is available in disclosure forms that your employer provides to you before enrollment, including the Summary Plan Description (SPD) and fee disclosure documents.
The most important thing is to sign up today, while it’s fresh in your mind. Life will get busy, and getting started is one of the most important steps.
Enrolling in your 401(k) is a matter of filling out forms, whether online, via an app, or on old-fashioned paper. Your Human Resources rep, benefits manager, or immediate supervisor should be able to point you in the right direction if they haven’t already. On the enrollment form, you’ll start by providing basic personal information like your address, date of birth, and Social Security Number.
Decide How Much to Save
Next, instruct your employer to take money out of your paycheck and put it away for your future. You can often specify a dollar amount per month or a percentage of your pay. In many cases, a percentage of your pay is a good choice because your contributions will increase as your pay increases — the better you do, the more you save.
Get the match: If your employer matches your contributions to the plan, contribute at least enough to get all of the matching funds available. Especially with a dollar-for-dollar match, there are very few good reasons to contribute less. You’re getting free money with zero risk—something that’s rare in this world. Your match might be explained as “100% of the first 3%, then 50% of the next 2%” or “dollar for dollar up to 4%.”
Pick a comfortable number: Determine how much you can comfortably live without each month. You don’t want to get in over your head and have a bad experience that scares you away from saving (possibly for the rest of your life). But at the same time, the more you contribute, the better—you should end up with more money later.
How much “should” you save? Make a plan. Ideally, a basic plan or retirement projection tells you how much it takes to reach your goals. But if you don’t have time for that right now, just get started with a number you can live with.
Rules of thumb: It’s tempting to ask what other people contribute or “what’s a good start?” but rules of thumb are problematic. It’s best to do a basic retirement projection, and it doesn’t need to be extremely time-consuming, especially when you’re starting. There are numerous calculators that can help with this. You can save for retirement in 15 to 20 years—or over the course of a much longer life, depending on your situation.
Do what you can: If you run some numbers, you might find that you’re “supposed to” contribute a lot more than you can comfortably afford. Just do your best, and don’t let this prevent you from saving. You can always make changes later, and it’ll be a lot easier if you start now.
Pre-tax, after-tax, or both? In many plans, you can make Roth 401(k) contributions as well as traditional pre-tax contributions. If you’re indecisive, no problem—you can do both. Pre-tax contributions are easier on your budget this month, but you’ll have to pay taxes on that money when you take withdrawals and spend it. Roth might allow you to prepay the taxes and withdraw everything tax-free in retirement (assuming you follow all of the IRS rules, of course). If you’re going to save 15% of your pay, you can do 8% pre-tax and 7% Roth—or mix and match however you want.
Minimums? You can typically enroll with just a few bucks per month or whatever is possible given your budget.
Before You Pick Investments
When money goes into the plan, how will it be invested? Your plan probably offers investments that range from aggressive to conservative (and everything in-between).
Aggressive investors hope to grow their money as much as possible over the long term. They use aggressive investments (like investments in the stock markets) that are likely to go up and down — sometimes dramatically — over the short term. These investors hope they will be rewarded for taking risks. Over long periods of time, such as 10 years or more, these investments will hopefully provide positive returns and growth. But there’s also a high likelihood of losing money — at least temporarily — at some point in time. You lock in those losses if you sell when you’re down. Sometimes you need to sell because you need the money, and sometimes you sell because you’re unhappy about what your investments are doing.
Conservative investors are less interested in growth. They are more concerned with reducing losses when the markets get crazy. They tend to prefer safer investments such as cash and bonds, but those investments are not completely risk-free. Conservative investors take the risk that they won’t earn enough to keep up with inflation, and bonds can lose money in several situations (such as when interest rates rise).
You can be completely on one end of the spectrum or the other. Or you can find a place in between the extremes. It’s possible to go for some growth without putting all of your money at risk.
What should you do? The textbooks say that the longer you have until you need the money, the more aggressive you should be (presumably you won’t use the money until you retire). Time allows you to go for growth and recover from market crashes that are likely to occur from time to time. As you get closer to the day you’ll start withdrawing money, the textbooks say to ease up on your risk and shift assets from stocks to safer investments.
That’s a pretty decent textbook approach. But we don’t live in a world where the textbook is always right. You need to decide for yourself if you should be more or less aggressive than your age would suggest.
What other factors matter? Will you get uncomfortable when markets crash and sell to reduce your suffering, or will you ride it out (assuming the markets recover and move higher than they were previously)? What happens if you lose money — would you be better off with a “bird in the hand”? How will you and your family be affected by the choices you make?
It’s often wise to use a risk tolerance questionnaire to help think about and get suggestions.
Types of Investments
Now that you’ve thought about who you are as an investor, you can choose specific investments to put your money into. In most 401(k) plans, you have several choices: You can do it all yourself, or you can have your 401(k) provider do some of the work for you.
Let’s assume you don’t want to do all of this yourself (otherwise you wouldn’t be reading this — you’d be off researching statistics and picking funds).
There are three basic types of investments, and you probably have access to a few alternatives in your retirement plan as well:
- Stocks represent ownership of a company. They tend to be higher on the risk/reward spectrum. The goal of using stocks is to grow your money over long periods of time (over 10 years, for example) — while knowing that you will sometimes lose money. To invest in stocks, you need to believe in long-term growth in the economy and the companies you’re investing in.
- Bonds are like loans. You lend money to an organization (a company or government, for example) and expect to get your money back along with interest payments. The goal of using bonds is to receive income and dampen the ups-and-downs of the stock market. Bonds are traditionally viewed as having less market riskthan stocks, but you can still lose money in bonds.
- Cash is a stable investment. Instead of trying to grow your money, you’re trying to conserve it when you invest in cash. You might earn a small amount of interest, but don’t expect much. On the bright side, you are unlikely to experience the volatility that can come with stocks and bonds.
Diversification: No matter what you invest in, it’s often wise to spread your money among various investments to manage your risk. For example, it’s risky to only own one stock, because all of your eggs are in that one basket. If something bad happens to that company, 100% of your investment is affected. If you own multiple stocks, you won’t suffer as much if one of the companies falls on hard times. You can diversify among types of stocks, different countries, and more. You can also diversify bonds and other investments. Diversification can potentially reduce your risk, but it doesn’t completely eliminate risk.
Mutual funds: Most plans offer mutual funds as a basic investment choice. A mutual fund is a pool of money that invests in numerous underlying investments and has an investment objective. For example, a stock mutual fund might own 100 or 1,000 different stocks, and a bond mutual fund might own a variety of bonds. Mutual funds can help you diversify, but you still might want to diversify among the types of funds you use. For example, you might put some of your money in U.S. stock funds, some in overseas stock funds, some in long-term bonds, and some in short-term bonds.
Asset Allocation Funds
If diversifying seems like more than you want to do on your own, an asset allocation fund can handle diversification for you. You just choose one investment, and the fund will spread your money among various types of underlying investments — often buying numerous other mutual funds or exchange traded funds (ETFs).
Some people don’t have the time to put into researching investments, diversifying, and repeating the process each year. If we’re being honest, most 401(k) participants fall into this category — they’re busy with other things, and they might not enjoy or understand the work it takes to manage investments (especially without making ill-advised choices). Asset allocation funds are a decent option for people who just need to sign up for the 401(k), get a diversified investment mix, and get on with life. These funds are the easiest to use, but there’s a risk that you’re making it too easy on yourself and picking the wrong fund.
Which investment should you choose? Again, it depends on your goals and your situation. It’s always worth asking your 401(k) provider for guidance and education. To find asset allocation funds in your plan, look for words like “moderate investor” or “target date.”
Target-risk funds aim for a specific risk level. They might be aggressive, conservative, or moderate. The more aggressive they are, the more stock (and overseas stock) they hold. Conservative funds typically hold less stock and less-aggressive stocks, allocating more to bonds and cash. Again, to reach the desired risk level, these funds might own somewhere around 10 to 30 different underlying funds (or hundreds of individual stocks and bonds). However, you don’t need to pick those investments or create the mix — it’s all done for you.
Target date funds use the same approach, but they add a twist: They can reduce risk over time. These funds typically have a year in the fund name (such as the 2055 fund), and that year helps you understand how much risk the fund takes. The year is the target date when you’d start spending the money from your investments (presumably the year you reach retirement age, although you can use any year you want). If that year is way out in the future, we go back to the “textbook” philosophy saying longer-term investment horizons can take more risk. If the year is just a few years out, the fund would presumably have less risk — but most target date funds keep you invested in stocks even after your retirement date to attempt to combat inflation.
The danger of autopilot is assuming something works (when it doesn’t). These funds make it extremely easy to diversify, but they might not be built the way you want. Don’t assume a fund is safe or risky until you actually see how it’s invested. Pick a fund that meets your needs based on how it’s designed, which might mean using a year that doesn’t line up with your projected retirement year.
Pick a Beneficiary
You’re almost done. The next step is to choose who should receive assets in the event of your death. You’re not required to choose a beneficiary, but you might want to. The beneficiary designation makes it fast and easy for this person (or multiple people) to claim your assets: They don’t need to wait for your will or the probate process.
Override the will: Be aware that your beneficiary designation overrules your will. Whatever you write on a valid beneficiary form can happen before anybody reads the will. If your will says that Susie gets the money, but your beneficiary form says that Julie gets the money, Julie gets it because the assets can skip going to your estate or probate. Make sure everything looks the way you want it to.
No beneficiary: What if you don’t choose a beneficiary? There are several potential outcomes. In some cases, your retirement plan assigns a default beneficiary. This is often a surviving spouse or next of kin, and that might not be what you want. Confirm how things work before you decide not to submit a form. In other cases, the funds simply go to your estate. At that point, they may be distributed according to the instructions in your will, or according to state law.
Kids: Parents often want to name their children as beneficiaries. That makes sense, but minors are not allowed to own most types of financial accounts. If the money goes to a child, in many cases, an adult (possibly somebody you wouldn’t choose) becomes responsible for handling the money until the child reaches the age of majority. There are ways to make arrangements before your death and improve the chances of things working the way you want. Talk with an estate planning attorney or do more research before you submit your beneficiary form.
Submit your Information
Going forward, you can make changes to things if you want. It’s a good idea to revisit your choices every six to twelve months. You certainly don’t need to watch your account daily or monthly — and it might be a bad idea to do so. Remember, this is a long-term investment, not a game.
Verify contributions: Check your next few paychecks to ensure that the funds are being taken from your pay, and log in to your 401(k) account to verify that the money arrives in your account. In rare cases, employers miss something (and in even more rare cases, they hold on to your money), so a quick checkup is always wise.
Watch fees: Your 401(k) plan is not free, even if you don’t see the fees. You’re likely paying fees to money managers, recordkeepers, financial advisors, administrators, and more. Pay attention to how those fees are charged, and learn how much you’re paying. You should receive official Fee Disclosure documents at enrollment, and annually. The more money you have invested, the more important this becomes. Speak to your employer if you’re concerned about how much you’re paying.
Save more: Almost nobody has too much money in retirement. If you’re one of the unlucky few who reaches financial independence early, well… you’re financially independent. Try to increase your contribution — even by a little — every year (or more often if you want). More is always better in this case, but even small increases add up: If you can add 1% of pay or $10 per month, it’ll help.
Don’t tinker: Once you do a good job of making a plan and evaluating your investment needs, avoid making frequent changes. You should only change your investments when that change fits with the long-term plan. Timing the market is dangerous, and it’s best to just make consistent additions to your account, whether the market is high or the market is crashing. Let time work for you and avoid costly mistakes.
Update your plan: Things change. At least every few years, evaluate how much you’re saving to see if you’re on track. Are you using the right investments for your needs?
A Word About Risk
It’s important to understand that investments — including “safe” money market mutual funds — can potentially lose money: You might walk away with less than you put in. It’s even theoretically possible that you lose 100% of your money.
Before you decide investing is not for you, consider the alternatives. First, it’s extremely unlikely that you’d lose 100% of your investment if you’re diversified among numerous investments (using a mutual fund with hundreds of stocks, for example). If that were to happen, it’d probably be concurrent with a major world disaster or economic collapse, and your 401(k) is the least of your worries. Things like shelter, crops, and radioactive protective gear might be more important.
There’s also a risk of avoiding “risky” investments. We’ve mentioned inflation, and that’s a real thing. How are you going to build up enough money to reach financial independence? It’s possible to do so by putting money into FDIC-insured bank accounts, but it’s substantially harder that way — you need to save a lot more or work a lot longer, or both.
Past performance is no guarantee of future results, but it’s the only data we have. Look at your options, think long term (to the extent possible), and do what you can to manage all of the risks you face — not just the ones they talk about on the news. It’s easy to be scared about investing – and acknowledging risk is good. For a dose of optimism and a big picture view, see JP Morgan’s Principles of Investing (specifically Section 3 and Section 6).
Important: This page touches on complicated topics related to tax, employment law, and estate planning. The information on this page might not be accurate, up-to-date, or relevant to your situation. Do not make important decisions based on what you read here. Instead, speak with an expert who has a detailed knowledge of your situation and any applicable regulations.