Finding yourself lost when people around you start mentioning stuff about a 401k? It’s time for a Nav.it 101!
A 401k is a retirement plan – that’s the basis of the basic. You can only have a 401k plan through your employer. Employers fund your 401k through your paycheck. When you get a job with a 401k benefit, you can set aside a portion of your paycheck to go into your retirement fund. Some employers, depending on your employee benefits, will even match the amount you contribute up to a certain amount (often around 3%–if you have multiple job offers, be sure to compare this benefit). If your employer matches your contribution it can double your contribution, which is a sweet benefit to take advantage of!!
The money you’re contributing is then invested into the stock market or into government bonds by your employer’s bank or investment firm. This way your money is growing while you contribute to it. FYI: You get to decide how much goes into stocks –considered higher risk, but higher potential yield–versus bonds –considered lower risk, but lower yield, see below.
Investing in stocks and bonds is what financial planners recommend to build your wealth. There is this crazy thing called compound interest which is basically interest on interest. Interest is gained on the amount of money you put into your investment (your profit if the investments rise) and then interest is applied to that interested amount plus your principle investment. So your money grows faster than it can anywhere else (think your basic savings account interest of .06%). Most financial planners suggest you diversify your portfolio with both stocks and bonds, depending on your age.
Fees: Depending on your plan, employers sometimes pay the fees associated with having a 401K managed by investment firm. Check out what fees exist on your portfolio and who is paying them (you or your employer?) so you know exactly where your money is going. Some investment firms have annual fees, others have a fee based on a percentage of your portfolio. This might not be clear at first, but you have EVERY right to ask your employer!
What’s the catch of a 401k?
401ks are a great way to save for retirement however, to protect both the employee AND the investment, the U.S. government regulates 401Ks. That means that while the fees on 401ks are typically lower than normal brokerage investments, an employee can’t start withdrawing the money in their 401k retirement account until the age of 59 ½ unless they pay an early withdrawal penalty. So if you’re stashing your money away in a 401k be prepared not to touch it until you reach 59 ½ years old..
Are there options?
Yes! There are two types of retirement 401k plans. Depending on your employer’s plan, you can choose between the Roth 401k or the Traditional 401k. The biggest difference between the two is the taxing options. With a Traditional 401k, your contributed wages are not taxed until you withdraw your money. Some people don’t like this option because you may be (hopefully!) at a higher tax bracket when you retire, therefore you will pay more in taxes on the money received. With a Roth 401k, your wage contribution is taxed when it is contributed and you aren’t taxed (again) at retirement. Some employers allow for employees to choose to tax half of their contributions and not the entire amount.
So what do you have to do?
The first thing you have to do is decide how much you want to contribute to your 401k. If you’re sticking to the basic rule, you should contribute the maximum amount that your company can match. This way you are maximizing your benefits. The most important point is to make sure your money management is in order so that you are not contributing more than you can afford.
The second thing you want to do after deciding your contribution amount is to shop through the investment packages and decide where you put your money. Your 401k will be managed by a specific bank or firm that your employer has chosen. This bank will offer investment options. They usually give you a risk assessment at the time of enrollment that is based on your age and your risk tolerance (i.e. are you willing to risk your money to make it big (stocks, with potential loss), or do you prefer to play it safe and invest in a diversified portfolio (stocks AND bonds) that may make less money over time but will be a less riskier investment)? This is also your chance to use your wallet agenda and invest your contributions into companies you trust and align your values with.
After you’ve done both these steps, your 401k should be set. You’ll need to keep an eye on your plan and manage it when needed, i.e. changing jobs, increasing or decreasing your contributions, and adjusting your diversification. In principle, your employer’s investment firm is there to help, so feel free to email them questions and check in once a year. Remember, they work for you.
Image credit: Mirjana Jesic