401(k) confusion is a real thing. You may have just started your first real job. How are you supposed to figure this retirement stuff out, too? There are tax considerations, investment decisions—not to mention finding the money to save.
Sure, it can seem overwhelming. But here's the thing: Starting to save and invest in your 401(k)—or 403(b) for some workers—may be easier than you think. The secret is to start saving early in life and invest in a mix of different kinds of investments to help your savings grow over time.
The secret is to start saving early in life and invest in a mix of different kinds of investments to help your savings grow over time.
What is a 401(k), anyway?
A 401(k) is a retirement plan offered by employers that gives you some tax benefits as an incentive to save for the future. Many employers automatically enroll new employees into their 401(k) and then let you opt out if you choose. Of course, you shouldn't assume you're automatically enrolled; be sure to find out how your employer does it.
There are two types of 401(k) contributions: Roth and traditional. Contributions to a traditional 401(k) are made before taxes. That means you get the tax break now—your contributions come out of your paycheck pretax, which reduces your taxable income. You pay taxes on what you withdraw from the account upon retirement.
Contributions to a Roth 401(k) are after-tax. Because the contribution is made after taxes are taken out, you don't get a tax benefit today—you get it in retirement. After age 59½, withdrawals of contributions and earnings are tax-free.* Any matches made by your employer are made on a pre-tax basis, so whether you contribute to a Roth or traditional, you will still get tax-deferred benefits. Not all employers offer Roth contributions however.
In addition to the sweet tax benefits, there's often another perk of saving in a workplace plan like a 401(k)—the employer match. Some companies offer to match your contribution, for instance, dollar for dollar, 50 cents on the dollar, or up to a certain percentage of your income. For example, if an employee makes a 5% contribution, the employer may match the entire thing. Be sure to contribute enough to get the entire match—it is basically free money.
If you're automatically enrolled in your 401(k), the default contribution level may not be enough to capture the entire match. If it isn't, consider changing your contribution amount—something you can usually do online or over the phone. Talk to your plan administrator or HR rep if you're not sure how to do it.
How much should I contribute?
Fidelity suggests saving at least 15% of your pretax income for retirement. That 15% includes any match you may get from your employer. Beginning to save 15% of income at age 25 can help you maintain your current lifestyle in retirement. If you start later, after age 25, it may require saving more than 15% of your income depending on your retirement goal—or working longer.
Of course, you're probably already paying down debt, setting up an emergency fund, saving for short-term goals like moving or buying a house, and, of course, just paying the bills for necessities, but retirement is also important.
What about investing?
The act of saving for retirement, by contributing money to a retirement account like clockwork, can only take you so far. You also need to invest your money so it can grow.
If you're automatically enrolled in your plan, your money will be invested in a default investment. Target-date funds are one type of default investment. They represent a do-it-for-me option that takes care of the details of investing for you.
But you may be more inclined toward DIY-investing. You don't have to become a professional trader or spend your free time researching stocks to develop and implement an investment plan. Using basic principles of asset allocation and diversification—to invest in a way that matches your time frame, risk tolerance, and financial needs—will help you get on the right path to achieve your retirement savings goals.
Some types of investments do the asset allocation for you. A target-date fund can create a diversified mix of investments for an investor like you.
Target-date funds are managed with a focus on a particular retirement year. If you're planning to retire in 30 years, you could pick a fund with a target retirement date of 2045 or 2050. The target-date fund that is aiming for the year closest to your anticipated retirement year will invest in a mix of investments appropriate for that time frame. As the targeted date nears, the mix becomes more conservative—typically by dialing back the level of stock investments and increasing investments in bonds.
Managed accounts invest in a mix of investments that reflects your personal risk tolerance and time frame. The investments are rebalanced regularly to maintain an asset allocation that is generally appropriate for an investor like you. With a managed account you get the opportunity for more personalized investment solutions that can change to reflect your evolving needs and circumstances. There's typically a fee for the service plus the cost of the underlying investments.
Digital investment managers and robo-advisors are other professionally managed options that you may have heard about recently. A robo-advisor may offer algorithm‐based portfolio models with little to no human interaction. A digital investment manager can give you human interaction plus other features. For instance, some digital investment managers offer a blend of managed account with some digital interfaces and some limited opportunities to consult with a live customer service representative.
If you think you have the will, skill, and time to manage your own savings, you should be sure that you understand the concepts of asset allocation and diversification.
Asset allocation refers to the way you split your investment mix among asset classes. Diversification is the benefit you receive from asset allocation.
If you become a do-it-yourself investor, it is important to start with asset allocation and understand the appropriate level of risk for your specific goals. The appropriate asset mix should reflect the length of time you plan to stay invested, your tolerance for volatility, and your financial situation. Once you determine how you want to be allocated, then you can focus on picking securities—being sure to pick a diverse array of investments.
Don't fear the 401(k)
One of the best things about a 401(k) is that it doesn't require a lot of maintenance. After you've set your contribution and chosen the investing style that works for you—DIY or do-it-for-me—and picked your investments, you only need to revisit the account every so often. You should consider checking in at least once a year or when something big happens in your life, like a new job or getting married—to make sure that your asset mix continues to reflect the time frame you have for investing, the amount of volatility you can withstand in the account, and your financial situation.
Because the contributions are taken right out of your paycheck, chances are you won’t even miss the money. When you do eventually retire, you’ll be thankful that you started early.
Take the next step
Whether you're thinking about setting up a 401(k), or already contribute to one, this tool can help you see the difference making a 1 percent increase to your 401(k) contribution can make for your future.