A 401(k) plan at work can be your best asset for retirement planning, but there are some things you need to know.
In this segment of Industry Focus: Financials, Motley Fool analyst Gaby Lapera talks with Dan Caplinger, a Motley Fool personal finance expert contributor, about what you should think about while filling out your initial 401(k) paperwork at work, including choosing the amount to save, investment choices, and taking advantage of employer matching if it's available.
A full transcript follows the video.
This video was recorded on June 19, 2017.
Gaby Lapera: Let's talk about the other really important thing when you first start working. Hopefully you're working at a company that offers this. You start work, you're handed all this paperwork, and among that paperwork is 401(k) paperwork. Dan, tell us about 401(k)s.
Dan Caplinger: Basically, the 401(k) is a way for you to get a jump start on saving for retirement. That might be the thing that you think is the furthest from your mind, but there are some really good reasons why you ought to think about putting at least a small amount of money toward your retirement. The first and most important is that most employers are going to make it worth your while to put a small percentage of your salary in your 401(k). The way that they do that is by matching your contribution. For instance, a lot of companies, if you save up just 3%, $0.03 out of every dollar that you make, they will match that with an equal amount from their own pocket. Basically, if you're making $200 out of every paycheck, 3% of that is $6, so your $6 will go into the 401(k), and then your employer will add an additional $6 in there. Now, that doesn't sound like much, and it's not, when you first start out. But over time, it builds up. And over time, as your salary goes up, those percentages automatically adjust as well. So, the combination of those two things, along with the investment growth that you get along the way, can really help you turn what seems like small amounts of money into enough to help give you the retirement security that you need after the end of your career.
Lapera: Yeah. And just to be clear, guys: This is free money. You don't have to do anything extra to get it, you just have to make sure that you put money into your 401(k). The other thing you want to do is make sure you max out your match. If your employer offers up to 9% matching, put 9% of your paycheck into the 401(k). And if you do it as soon as you start working -- because you can elect how much goes into your 401(k) with all of that initial documentation -- you won't even miss the money, because you won't be used to seeing it in your bank account. So, once you have your 401(k) open, depending on your employer, you will be able to go in and pick what funds you put your money into. The funds are generally index funds, mutual funds, ETFs. They have a variety of different characteristics, and we're going to give you a little bit of advice on how to pick on that best suits you. For me, the most important thing is fees.
Caplinger: I agree with that 100%. Fees are something that, basically every dollar that goes to the company that manages your 401(k) is a dollar that is taken away from you. So, picking funds like index funds that have low expenses are really usually the best way to go, especially for someone who's just starting out.
Lapera: Definitely. Generally, if you see a fee that is 1% or more, that is way too high. Honestly, anything above 0.7% or 0.5% is way too high for me. You can get funds with extremely low fees. The Vanguard S&P 500, one that I have, is 0.05%. Those are the ones you want to be looking for. And you might not think it adds up over time, but if you want, I will send you an article that explains how those fees cut into your returns over time.
Caplinger: Yeah, it's extraordinarily surprising to find out. And again, it's because these dollar amounts grow over time. If you're only making a $6 contribution, it doesn't make that much of a difference. 1% of $0.06, 0.5% is $0.03, it's not a big deal. But, as these monies grow and accumulate, then suddenly you're starting to talk about real money, and even these small percentages really add up.
Lapera: Definitely. So, before I forget, potentially, you're filling out your 401(k) paperwork, and you might get to a point where it's like, do you want a Roth 401(k) or a regular 401(k)? What does that mean?
Caplinger: Basically, the 401(k) world recently caught up to the rest of the retirement world. We've had this thing call the Roth IRA for about 20 years. Basically, what it does is flips the usual retirement account scenario on its head. It used to be, the only kind of retirement contributions you could make, you would get an upfront tax deduction for the contribution that you make, but then you would have to pay taxes on the money when you took it out in retirement. That's great for somebody who's high-income right now, because their tax rates are really high, and they're losing a lot of it to taxes. They would love to get that write-up. But for people who are just starting out in a low tax bracket, usually they're just better off if they pay the taxes now, if they can get the promise of tax-free treatment later on when they take the money out in retirement. That's exactly what the Roth option in the 401(k) does. Not every employer who offers a 401(k) will have that Roth option in there, so don't be surprised if your employer doesn't offer it. But if it does and you're just starting out, take a really close look at that Roth option, because a lot of the time it's going to be the best long-term solution for you with your finances.
Lapera: I know with a regular IRA, there's income limits with who can contribute to it. Is that true of a Roth 401(k) as well?
Caplinger: No, it's not. That can be really helpful, if you're one of the fortunate few who comes out of school with a relatively high salary, then you're in a position where you might not be able to do a Roth IRA, because like you said, those IRA contribution limits apply. There's no income limit for Roth 401(k) contribution, so that gives you the opportunity to get into that Roth option in a way that can really help you out.
Lapera: Definitely. And not that it makes much of a difference to you -- you should make your own decisions based on your life -- but, I have a Roth 401(k), and I love it.