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Retirement 101: 401(k) Basics

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As defined benefit plans face extinction, employees are increasingly responsible for financing their own retirements. Fortunately, 401(k)s and other retirement vehicles give today's employees a savings boost, through employer contributions and other incentives. And while the transition from pensions to 401(k)s has been a rough one -- especially through the recession -- investors are recovering. According to data released earlier this month by Fidelity, the average 401(k) balance is up 11.1% from this time last year, to $84,300. It seems 401(k)s are here to stay, so it's time to get informed.

How do 401(k)s work?
401(k) plans allow you to set aside a portion of your pre-tax wages toward retirement. Your employer administers them and, in many cases, will even match a percentage your contributions. If at all possible, contribute enough to your 401(k) to receive the maximum employer match. It's free money and can make up as much as half of your retirement savings, especially if you're a millennial.

Note that not all employers offer 401(k)s, and not every employee is eligible. If you aren't, you can set up an Individual Retirement Account, or an IRA. Even if you do have a 401(k), you might also want to set up an IRA simply to maximize your retirement savings, because both account types limit contributions. In 2014, you'll be able to contribute $5,500 to an IRA, in most cases, and $17,500 to a 401(k).

What are the advantages of 401(k)s? 
There are a few major advantages to saving in a 401(k) over a traditional bank account: 

  • Tax deferral. Your 401(k) contributions are deducted pre-tax; instead, you pay taxes on the money when you withdraw it in retirement. If you expect to make more money in the future, this is a partial disadvantage, but there are some upsides. For example, if you devote 6% of your salary toward retirement, that 6% comes out of your gross salary, not your after-tax salary. And the amount you contribute lowers your total tax bill.
  • Investment options. The money you put in your 401(k) is generally invested in mutual funds. Your plan should give you some choices. If you can't decide which would be your best bet, try this tool to compare funds. Target-date funds, which automatically adjust your money's allocation from higher- to lower-risk investments as you age, are also becoming a popular option.

What are the disadvantages of 401(k)s? 
Unfortunately, 401(k)s have one big downside: fees. You'll probably be charged three levels of fees through your 401(k):

  • Expense ratio fees. This is your fund's operating expenses, including compensation for the fund manager, legal fees, marketing expenses, and other business-related costs.
  • Other mutual fund expenses. Other fees related to your fund aren't disclosed in the expense ratio but can add up nonetheless. These might include fees for buying or selling stocks and bonds in your fund, among trading costs.
  • 401(k) plan fees. On top of these, your 401(k) plan takes a cut for managing your money. This goes to pay the employees at your plan, including those involved in customer service and brokers, as well as for other materials and services.

Altogether, these fees can cost more than $150,000 in a lifetime for some families. Fortunately, you can minimize them. The expense ratios of available funds are usually easy to find, so compare them to ensure you're getting the best deal. And look out for index funds. They have fewer associated fees than actively managed funds. 

What if you leave your job?
Most companies will ask that you take your 401(k) funds with you if you switch jobs. Rather than cashing it out, you should roll over your savings into an IRA. This will probably lower your plan fees -- possibly to nothing -- and give you a wider range of investment options, and fortunately, it's easy to do. If you already have an IRA, you can contribute your 401(k) balance to your existing account; otherwise, you'll have to contact your bank or brokerage and set one up. Once you have an IRA, let your banker or broker know you'd like to execute a rollover, and they'll handle the rest.

The bottom line
While 401(k)s are definitely more labor-intensive than a pension, they're nothing you can't handle. Once you've opted into your company's plan and made some basic decisions about how to invest your money, there's not much more to worry about. Just consider meeting with an advisor every so often -- many people do this once a quarter, or once a year -- to rebalance your portfolio and check on your progress. If you need to roll over your 401(k) into an IRA, find a broker that best suits your needs and offer a wide variety of mutual funds, such as Scottrade or TD Ameritrade.

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