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The Best Way to Use Your 401(k)

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In today's economy, you have to make the most of your paycheck. Whether you're just starting out in the working world, switching to a new job, or focusing on your finances for the first time, your employer could play a big role in your financial planning. If your employer offers an employer-sponsored retirement plan like a 401(k), then taking advantage of it will get you started on the right foot.

Getting past the flak
You may have heard lots of bad things about 401(k) plans lately, though. Thanks to the bear market, many workers have lost a lot of money in their retirement accounts since 2007. In addition, other negative aspects of 401(k)s, including hidden fees, dubious and limited investment choices, and employer cutbacks to profit-sharing and matching contributions, have made many question whether they should use 401(k) plans at all.

But just because some 401(k) plans aren't ideal doesn't mean that yours is a bad plan. So make sure to take a close look to see how your 401(k) works.

Other contributions?
The first thing you should do is figure out what benefits your 401(k) plan offers. The most important questions to ask are:

  • Does the plan offer an employer match? Plenty of companies, including American Express (NYSE: AXP  ) , have suspended matching contributions. But if yours still does, then your employer is basically giving you free money as an incentive to participate. A plan has to be pretty bad before it makes sense to turn that free money down.
  • Will you get profit-sharing contributions? In some cases, employers make additional contributions based not on how much you contribute but rather on your salary. Find out what if anything you need to do to receive those contributions.
  • When does your plan money vest? Your own contributions vest immediately, but money that your employer puts in on your behalf may take years to vest. That means if you leave your job before that point, you might have to give back some or all of that money. It's something to consider if you don't plan on staying at a job very long.

The answers to these questions will give you a better idea of exactly what extra incentives you have to participate in the plan. But equally important are what investment options you can choose.

Find the right investments
Most 401(k) plans primarily offer mutual funds for workers to invest in. But the range of funds offered varies widely from plan to plan. Some plans will only give you a few choices with a single fund in each investment category, while others may include dozens of funds to choose from.

Young workers have a long time before they have to worry about retirement. So if you're just getting started, you should focus on the more aggressive options that your plan offers. In particular, based on some asset allocation recommendations from our Rule Your Retirement service, here's a road map to one possible way to invest your 401(k) money:

  • Thirty-five percent in a large-cap U.S. stock fund that invests in big, well-known companies like Microsoft (Nasdaq: MSFT  ) and Procter & Gamble (NYSE: PG  ) .
  • Thirty percent in a fund that owns mid- and small-cap stocks such as priceline.com (Nasdaq: PCLN  ) and Red Hat.
  • Twenty-five percent in an international stock fund, which may include both developed-country stocks like BP (NYSE: BP  ) and BHP Billiton (NYSE: BHP  ) as well as emerging-market companies such as America Movil (NYSE: AMX  ) .
  • Ten percent in a fixed-income bond fund.

Those closer you are to retirement, the more conservatively you will want to invest. If you have a choice of funds, pay particular attention to fees -- sticking with less-expensive funds can save you a ton of money over the long haul.

Watch your taxes
Another benefit of 401(k) participation is the tax break you get. Don't expect to see a big refund, though -- most employers just adjust your withholding, so you receive your tax savings in small chunks throughout the year. If you're in a low bracket, ask if your plan has a Roth 401(k) option -- the tax-free growth you'll get may be worth more than a current deduction in the long run.

Despite their critics, 401(k) plans are a great way to start investing. So as you begin your career, take some time to find out how your 401(k) can help you save for retirement. Your future self will be glad you did.

Want help investing your 401(k)? Then you'll want to take a closer look at our Motley Fool Rule Your Retirement serviceOur combination of retirement and mutual fund experts can help you craft a winning investment strategy in your retirement accounts. Get started today with a free 30-day trial.

Fool contributor Dan Caplinger dove into 401(k)s head-first and never looked back. He doesn't own shares of the companies mentioned in this article. priceline.com is a Motley Fool Stock Advisor recommendation, Microsoft is an  Inside Value pick, and America Movil is a Global Gains pick. The Fool owns shares of Procter & Gamble, which is also an  Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is good for beginners and experts alike.


Read/Post Comments (1) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 10, 2009, at 9:07 PM, menefer wrote:

    Consider moving your 401K to a self directed IRA when you leave. At that point there are no reasons to stay in the 401K plan. The advantages of an IRA are that your former employer no longer has any control over your money or investment choices. You avoid all 401K fees and you greatly expand the investment choices available to you. You can consolidate the funds with other IRA funds or other 401K funds from previous jobs.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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