If you're new to the working world, you've hopefully managed to land a job with a number of benefits, including the ever-important 401(k). Though an employer-sponsored retirement plan may not seem quite as enticing as several weeks of paid vacation or free coffee and snacks, it's an important benefit you'd be wise to take advantage of. Here's a quick guide to saving in your first 401(k) and why it pays to do so.
How 401(k)s work
A 401(k) plan is a tax-advantaged retirement plan designed to help you build a nest egg for the future. Once you sign up for your company's plan, you'll have the option to choose how much of your earnings you want to contribute. That amount will then get deducted from each paycheck, which means you don't actively have to write out a check or transfer money every month.
For 2018, you're allowed to contribute up to $18,500 to your 401(k) if you're under 50 (or $24,500 if you're 50 and over). If that sounds like a lot of money to part with, well, it is. But don't worry about hitting that max right away. Rather, save what you can today and aim to increase your contributions over time.
The good thing about 401(k)s is that contributions are tax-free. This means that if you put in $5,000 this year, and your effective tax rate is 25%, you'll shave $1,250 off your 2018 tax bill. Pretty neat, huh? Furthermore, once your money is in your account, it gets to grow on a tax-deferred basis until you're ready to take withdrawals in retirement.
Now one thing you do need to know is that once your money is in your account, you can't remove it until you turn 59 1/2, as doing so will trigger a costly early withdrawal penalty. But since the purpose of a 401(k) is to save for retirement, you shouldn't be tapping those funds prematurely anyway.
Another thing you should know is that the above rules apply to traditional 401(k)s. These days, a growing number of companies are offering Roth 401(k)s as well. If you're curious about how these plans work, you can read up on Roth 401(k)s here.
Making the most of your first 401(k)
Once you make the wise decision to participate in your company's 401(k), you'll need to decide how much to contribute and where to invest your money. For the former, the best advice is to put in as much as you can, but at a minimum, contribute enough to get your employer's match. In other words, if your employer will put in up to 5% of your salary provided you do the same, and you make $50,000 a year, be sure to contribute $2,500. Otherwise, you'll be giving up free money.
Next, you'll need to invest the money you contribute so that it grows into an even larger sum over time. In this regard, you'll want to go heavy on stocks, as opposed to safer investments, like bonds, because they tend to offer a higher rate of return. And while the stock market is risky, if you're young and just starting out, you have plenty of time to ride out its ups and downs.
That said, you should still keep some of your 401(k) in bonds as a means of diversification. A good rule of thumb is to subtract your age from 110 to determine what percentage of your portfolio should be in stocks. If you're in your early 20s, it means you should put 85% to 90% of your investments in stocks, and the other 10% to 15% in bonds. Then, as you get older, you'll want to shift toward a more even split.
In addition to choosing the right class of investment (stocks versus bonds), you'll also need to choose funds within those classes that offer the best returns with the lowest fees. In this regard, you have two main choices: actively managed funds and index funds.
With the former, you'll be paying higher fees (which can really eat away at your returns over time) in exchange for the advice of a hands-on fund manager. With the latter, your fees will be lower because you won't have an active fund manager overseeing your investments. That's because index funds simply seek to track existing indexes, like the S&P 500, which means that they typically move with the broader market. That said, the performance of index funds has, at least in recent years, been comparable to, if not better than, that of actively managed funds, so you might as well save yourself the hefty fees.
Starting a 401(k) when you're young is a great way to set yourself up for a comfortable retirement. Now that you're a little more familiar with how to approach your first 401(k), you'll hopefully manage to make the most of it.