Everything You Need to Know About Your First 401(k)

Image source: Getty Images.

If you recently landed your first job with a 401(k), welcome to the club! Your new retirement savings program may seem confusing at first, but it doesn't need to be. Here's a primer on what you need to know about your new 401(k) plan and how to set yourself up to build your retirement nest egg.

What is a 401(k), anyway?

A 401(k) is an employer-sponsored retirement plan that allows employees to choose to defer a portion of their compensation to save and invest for retirement. Money saved in a 401(k) is not taxable until it's withdrawn, which allows employees to maximize the compounding effects of investing. There are several advantages to a 401(k), and we'll go over some of the biggest ones in the next section.

Why save in a 401(k)?

Here are a few of the best reasons to put money into your company's 401(k) plan:

• Compound returns: This is the most obvious benefit of 401(k) investing, but many people don't realize just how powerful it is. Money you put into a 401(k) gets invested (more on this later), not just stashed in a savings account. The stock market has historically returned more than 9% per year -- which means if $5,000 goes into your 401(k) every year for a 35-year career, you could have nearly $1.1 million to retire with.
• Tax benefits:  Not only is the money you contribute tax-deductible, but the money grows tax-deferred. If you invested in a standard brokerage account, you'd have to pay taxes on interest and dividends at the end of the year.
• Easy retirement investing: Once you set up your 401(k), it will require minimal ongoing maintenance. Your employer will deduct your contributions from your paycheck automatically and put it in your account.
• Retirement planning advice: Most 401(k) plans offer some sort of free financial planning advice. Advisors can help you determine if you're saving enough, and they can help you select investment funds if you'd like.
• Loans: While taking a loan from your 401(k) isn't an ideal situation, it is usually an option. Having a substantial amount of money in your 401(k) can give you a "safety net" in the event of a financial emergency.
• Employer matching: Most 401(k) plans have some type of an employer matching program. This means your employer will give you free money just for saving for retirement.

How does "employer matching" work?

Most employer-matching programs are designed the same way. Your employer will match your 401(k) contributions, either dollar-for-dollar or at a set percentage rate, up to a certain percentage of your salary.

For example, let's say your employer's matching program is as follows:

Company XYZ will match 50% of your 401(k) contributions up to 6% of your gross pay.

This means if you choose to defer 6% of your salary into your 401(k), your employer will contribute an amount equal to 3% of your salary, for a total of 9% of your salary flowing into your account. If you choose to defer 4% of your salary, your employer will contribute 2%. On the other hand, if you choose to contribute 10% of your salary, your employer will only contribute 3% since the matching program is capped at half of 6%, or 3%, of your salary.

How much should you contribute?

There's no one-size-fits-all answer to this question, but at a bare minimum, you should contribute enough to take full advantage of your employer's matching program. Not doing so is literally turning down free money.

In general, I suggest 401(k) participants aim to save 10% of their salary, not including employer matches. This may seem like a lot at first, and you don't need to get there right away. Try increasing your contribution rate by 1% per year (many plans will let you do this automatically) or every time you get a raise. Keep in mind that the sooner you increase your contribution rate, the more of a long-term impact it will have.

As an example, let's say that your salary is $50,000 per year, and ignoring the effects of inflation, we'll say your salary increases by about 2% per year from now until retirement. If your employer matches your contributions dollar for dollar up to 5% of your pay, you could expect a nest egg of about $580,000 in 30 years, assuming 7% average annual returns.

This may sound like a lot, but according to the frequently used "4% rule" of retirement, it would only produce about $23,200 in annual retirement income. Even when factoring in Social Security, will this be enough?

However, check out the effect of increasing your contributions by a percentage point or two.

You are allowed to contribute up to $18,000 to your 401(k) in 2016, not including employer contributions, and an additional $6,000 if you're 50 or older. While it may not be practical or necessary to contribute this much, the point is that the limits are high, so take advantage.

Should you make Roth 401(k) contributions?

More and more plans are adding a Roth, or after-tax, option to their 401(k) plans. The biggest difference is how the tax benefits work. Unlike most 401(k) contributions, Roth contributions are not tax-deductible, rather, your eventual withdrawals will be tax-free.

The decision basically comes down to a choice of when you want your tax benefits, now or later. Here's a thorough discussion about Roth 401(k)s by my colleague Selena Maranjian that can give you all of the information you'll need about these, if you're interested.

How should you invest?

You can choose to invest the money contributed to your 401(k) in a selection of mutual funds, which depend on your particular plan. Some of these funds invest in the stock market (equity funds), some invest in bonds (fixed-income funds), and some just keep your money in cash and money market accounts.

In general, 100% of your 401(k) should be invested in either stocks or bonds. Younger investors should allocate a greater percentage of their account to stocks, as they tend to be more volatile but have the best growth potential over time. On the other hand, older workers and retirees should have more bond investments, as these don't typically grow your money as well as stocks, but they tend to do a better job of preserving your nest egg.

As a rule of thumb, take your age and subtract it from 110 to determine how much of your account should be invested in stock funds. For example, I'm 35, so I should have about 75% of my retirement assets in stock funds with the rest in bonds. Feel free to adjust this up or down a little to match your personal risk preference -- in full disclosure, about 85% of my 401(k) is in stocks.

Stock funds come in many varieties, and you'll see them labeled as large-cap, mid-cap, or small cap, as well as by growth and value. You may also see some funds labeled as foreign or international stock funds. The allocation I just discussed is far more important than the individual funds you select, as the options within a 401(k) plan tend to come with similar expense ratios. Here's a more thorough discussion on asset allocation.

For reference, here's how I have my own 401(k) allocated:

• 40% in a large-cap growth stock fund
• 20% in a small-cap value stock fund
• 25% in a foreign large-cap stock fund
• 15% in a bond fund

Target-date funds: The one-fund option

Yet another investment option is target-date retirement funds. These are the funds in your plan that have years in the title, such as "Target Retirement 2050." Essentially, these are designed to be an all-in-one retirement portfolio, gradually adjusting your allocation from stocks to bonds as you get closer to retirement.

If you prefer to take a hands-off approach to your retirement investing, and the target-date funds in your plan have comparable expense ratios to the other funds you could select, there's nothing wrong with choosing this option for all or some of your money. Here's a thorough discussion of target-date funds if you're interested.

When can you use the money?

Generally, you can use the money in your 401(k) after you turn 59-1/2 years old. If you withdraw the money in your account early, you could face a 10% early withdrawal penalty from the IRS on top of any income tax you owe.

There are a few exceptions to the rule. To name some of the most common, if any of the following criteria apply, you can use your money early:

• You've separated from service. If you're no longer working for the employer in the year you'll turn 55 (or later), you can start withdrawing from your account. This requirement is lowered to age 50 for public safety employees.
• You agree to take "substantially equal payments" that last at least five years, or until you're 59-1/2, whichever is longer.
• If you're ordered to do so as part of a divorce settlement.
• To pay qualified medical expenses above 10% of your adjusted gross income (AGI).
• If the withdrawal is used to cover unpaid taxes you owe.
• You die or become permanently disabled.

The bottom line on your new 401(k)

You should enroll and start contributing to your new 401(k) as soon as possible, as your investment dollars will never have more long-term compounding power than they do right now. With a little bit of knowledge, you'll be armed to make smart decisions about your 401(k) and to build the retirement nest egg of your dreams.