One of the most important financial goals you have is to provide for a financially secure retirement. That's a daunting task, but if you get started early, then you have your whole career to save and invest in order to grow your nest egg into a healthy amount that will support you long into your golden years. The tough part is actually setting aside that money for savings from your immediate needs. You can use all the help you can get in saving for retirement. This is where 401(k)s come in.

Millions of workers have employers who are also keenly aware of the importance of building up retirement savings. Employer-sponsored retirement plans, such as 401(k) plans, are a key tool for employees to set aside money on a tax-favored basis. Many employers even contribute directly to their workers' financial futures by matching a certain percentage of the worker's contribution. This is a rare instance of free money on the table, so you won't want to miss it. But how?

A bowl wrapped in dollar bills with three gold eggs inside, one of which says 401k

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If you're fortunate enough to work for a company that offers a 401(k) plan, then it's pretty easy to open a 401(k) account. If your employer doesn't provide this perk, you may be able to open a 401(k) on your own. Below, you'll learn everything you need to know about 401(k) plans and how to get started using one.

What's a 401(k)?

401(k) retirement plans are savings plans that employers sponsor, or pay for, that help workers save money from their earnings for their own retirements. The plans are established by provisions of Section 401(k) of the Internal Revenue Code and they also give employers the opportunity to make additional contributions of the company's money toward your retirement savings, usually through an employer match.

Although the 401(k) plan as a whole contains the total assets of all the company's employees, each employee has a separate account that holds their own contributions and any contributions the employer makes for that employee.

It's up to the employer to come up with a menu of investment options that workers select from in their 401(k) account. The range of investments available can vary greatly from employer to employer. Some employers offer a limited selection of mutual funds for participants to select from, while others make wider assortments of investments available. A few employers even offer full access to brokerage services, opening workers up to the entire investing universe.

What's so great about 401(k) accounts?

401(k) plans offer a number of attractive features to workers. The most important are the tax benefits you'll find in a 401(k).

Traditional 401(k) plans allow workers to make contributions on a pre-tax basis. Therefore, when you elect to make a contribution toward your 401(k), your taxable income for that year is reduced by the amount you contribute, in turn reducing your total tax bill for the year by the amount of tax you would have owed on the money that you instead contributed to your 401(k).

The other main benefit is that once your money is inside your 401(k) account, it grows on a tax-deferred basis. With regular non-retirement investment accounts, you typically pay income tax on any interest, dividends, or other investment income in the year you receive them. In addition, you owe tax on the gains in an investment when you sell it. Within a 401(k) account, though, any income or gains that your investments generate year after year aren't subject to tax as long as you keep all the money in the 401(k) account.

Eventually, though, you will have to pay taxes on the money in your 401(k), but those taxes don't come due until you withdrawing the money. When you do withdraw funds, the amount of money you take out will be added to your taxable income for that year and you'll pay your regular tax rate on it.

For most people, the opportunity means they'll move taxable income from a year when they are working, earning high income and paying in a high tax bracket, to a year when they're retired, bringing in less income and paying in a lower tax bracket. This can be a big financial boost for many. Not only can workers put off paying the IRS so their money benefits more from compound growth in their account, but it also results in lower overall tax outlays -- letting the beneficiary keep more of their retirement savings on an after-tax basis for themselves and their families.

Some employers also offer what's known as a Roth option in their 401(k) plans. Contributions to a Roth 401(k) are made with after-tax money, meaning that you don't get to reduce your taxable income in the current year by the amount that you contribute. The trade-off is that the money in a Roth 401(k) grows on a tax-free basis rather than just being tax-deferred. When you withdraw money from the Roth portion of your 401(k) in retirement, you won't owe any taxes on it.

How do you open a 401(k)?

If your employer offers a 401(k) plan, here are the steps for opening your 401(k) account:

  • Figure out if you're eligible.
  • Find out if your employer automatically enrolled you or whether you need to complete enrollment on your own.
  • Decide how much money you plan to contribute.
  • Choose appropriate investment options for your contributions.

Once you open your account, you'll need to do a few things on a regular basis, including reviewing the account periodically to see how it's doing, looking at your contribution levels to see if they're on track for your goals, and making occasional changes to your investments. As you approach retirement, you'll also want to look at your available options for withdrawing from your accounts.

Later on, we'll take a closer look at options for someone whose employer doesn't offer a 401(k). 

Am I eligible to participate in a 401(k) plan?

As long as your employer offers a 401(k) plan -- and it's easy to check with your human resources department to see if it does -- then most employees are eligible to participate. The laws governing these retirement accounts require employers to let employees participate if they're at least 21 years old and have completed at least one year of service with that employer, generally defined as working at least 1,000 work hours in a plan year. For this reason, many part-time employees end up being eligible even under the strictest plan guidelines, although some one-time seasonal employees might not be eligible. The employer can choose to be more inclusive, though, allowing all employees to participate regardless of how many hours they work.

The definition of "employee" is important here. If you're considered to be an independent contractor of the company you work with, then you will not be eligible for that company's 401(k) plan. If that's the case, you'll have to pursue other retirement saving options.

Talk to HR about enrolling in your 401(k)

Your company's HR department will be your first stop in opening your 401(k) plan. The people who specialize in handling employee retirement benefits are ready and willing to give you all the information you need to enroll and open your account.

Some employers actually enroll new employees automatically into their 401(k) plans. In doing so, they use the legally permissible option of setting default provisions for how much money to take out of your paycheck to contribute to the plan and select your investments for you. Lawmakers allowed employers to do this in order to encourage greater participation, but as the worker, you always have the final say in how your savings are managed. Even if your employer automatically started funding a 401(k) account for you, you can elect not to participate or change any of the selections your employer made.

Other employers require workers to say affirmatively that they want to participate in their 401(k) plans. In this case, you'll receive paperwork early on in your employment that gives details about the plan, including any employer match. You'll also find out whether your employer is working with an outside financial services firm to help it manage and invest the 401(k) plan assets, along with basic financial information about the plan.

Finally, one essential piece of information you'll need to provide is who you want to receive your retirement benefits in the event of your death. Your beneficiary designation for your account takes precedence over your last will and testament in determining who'll get the balance of the 401(k) account after you die, so making a smart choice is important.

How do I contribute to my 401(k) plan?

Once you decide to participate in your employer-sponsored retirement plan, the next step is determining out how much money to contribute to your 401(k) account.

With most employers, you can ask the payroll professional to withhold a fixed dollar amount from each paycheck or to contribute a set percentage of your gross pay.

It's up to HR to figure out whether you'll receive additional money through an employer contribution. Employer matching usually involves your employer depositing either 50% or 100% of the contributions that you make to your 401(k) -- a match that is up to a maximum percentage of your salary -- often 6%.

So if you make $50,000 a year and your employer offers a 50% match on up to 6% of your salary, then you would max out your employer's match by contributing 6% of $50,000 or $3,000 per year, to your 401(k). If you did that, then your employer would kick in half that, or $1,500, on top. Think of how far $1,500 can go in a tax-advantaged account over many decades. It's nothing to scoff at. 

Start investing your 401(k) account

Once you've established your 401(k) contribution, decide how to invest that money. Your employer handles transferring your contributions to the financial institution that actually invests your money, but you're responsible for choosing exactly which investment options to put your money in. Typically, whichever investment selections you make for your own contributions also apply to funds from employer matching or profit-sharing.

The investments that make the most sense for you depend on how extensive your menu of investments is. If you have a brokerage option with access to individual stocks, bonds, and other investments along with exchange-traded funds (ETFs) and mutual funds, then you can generally use the same basic investing strategy you use in managing your non-tax-advantaged investment accounts.

For most people, only a limited selection of investments are available. In that case, you'll need to balance the following factors:

  • As with most investments, fees involved with 401(k) investing are paramount. The lower the fee involved with a given investment, the more of its return goes into your pocket. Low-cost options like ETFs and index mutual funds can save you thousands compared to higher-cost actively managed alternatives.
  • Diversification lowers the risk of your investments as a whole. Many people choose a strategy with exposure to both stocks and bonds. Stocks have greater growth potential but more risk, than bonds, which offer greater security. Pick a fund in each major asset class, rather than just investing in random equities across multiple asset classes.

Your optimal investment mix will depend on your specific situation. Most investors feel comfortable allocating more money into stocks early in their career, because there's more time to recoup losses and enjoy compounding growth.

For instance, a common allocation during one's 20s and 30s is to invest 80% of your money in stocks, with the other 20% allocated to fixed-income investments like bonds. That allows you to put the bulk of your investments in assets that will maximize growth, giving you the best chance of meeting your long-term financial goals.

Later on, as your retirement nest egg grows, shifting a greater portion of your investments toward bonds and other fixed-income alternatives to stocks can reduce overall volatility and give you less risk of a devastating crash in the value of your retirement savings.

For instance, once you're in your 40s and 50s, you might shift to a more conservative allocation of 60% into stocks and 40% in bonds and fixed income. That would protect your portfolio in the event of a stock market downturn, and although it would reduce your potential growth in a favorable market, the reduced risk is worth accepting fewer prospective rewards. By the time you near retirement age, you might even have a majority of your assets invested in bonds, although given the need to plan for a retirement that can easily last 20 to 30 years or longer, having at least some money allocated to growth investment like stocks is almost always warranted.

Some investors do these adjustments on their own, but others prefer to have it done for them. Target-date funds are designed to make these changes automatically, with set target dates that match up to when a person expects to retire. For instance, a 2050 target date fund would currently be allocated mostly to stocks, because there's still more than 30 years to go before reaching the target date. As time goes by, the target date fund would shift away from stocks toward more conservative investments -- all without the investor having to take any action at all. Of course, that can be good or bad depending on what you want, because a target date fund won't match your exact philosophy. But many find it helpful to have those moves handled by the fund rather than having to remember to move money from one fund to another year after year.

How to maintain your 401(k)

Once you've opened your 401(k) account and hit the ground running by getting your employer's full match and allocating your funds into a diversified and properly allocated portfolio of low-cost investments, your job isn't over yet. Managing your 401(k) account is something you must continue to do throughout your career and even into your retirement years. For life.

Review your investments regularly to make sure they're behaving how you expected. As with any long-term investment, you can't expect the choices available in your 401(k) account to go up without interruption forever. From time to time, you're almost certain to suffer losses over the short run, especially if you invest a substantial percentage of your retirement savings in stocks.

However, what you can and should do is to compare the performance of the investments in your 401(k) account to how major market benchmark indexes like the Dow Jones Industrial Average or S&P 500 are doing. Many 401(k) providers offer tools that let you see the exact performance of your account's investments, comparing them to appropriate benchmarks. Even if your provider doesn't give such a report, you can still calculate your own return and compare it to popular stock indexes yourself.

If you find yourself routinely underperforming the benchmarks against which your funds should compare favorably, then you should consider whether an alternative investment choice might be better suited to your needs.

For example, if you've chosen an actively managed mutual fund that lags behind the market and you have access to a stock index mutual fund in your 401(k) investment menu, making the switch could give you more predictable and better returns.

Contemplate making changes to the amount of money you contribute to your 401(k). As your career progresses, your pay will probably rise gradually, which gives you more room to set aside cash for retirement. Some investors start off with a relatively small contribution of 3% to 5% of their pay, but then commit to boosting it by a percentage point each year until they reach the 10% to 15% range. This ensures an early start while also setting the stage for more meaningful contributions down the road when you're better able to afford them.

What if I don't have access to a 401(k)?

Unfortunately, not everyone has access to a 401(k). If you're an employee of a company that just doesn't offer a 401(k), check with your HR department and see if there's a different type of retirement plan you can use.

Some small businesses offer alternatives such as SIMPLE IRAs or SEP-IRA arrangements instead of 401(k)s. These don't always have the same limits as 401(k)s, but they can fulfill the same basic role.

If you're self-employed or own your own business, then you also have the option of setting up a 401(k) of your own. A vehicle known as the solo 401(k) gives sole proprietors their own 401(k) plan, in which they act as both the employer and employee in one plan. You  select your own investment options and determine how much to contribute. Contribution limits exist, but they're often much higher than what an employee would be able to contribute to an employer's 401(k) plan, ranging to as much as $55,000 for those under 50 or $61,000 for those 50 or older in 2019.

A solo 401(k) can be a great choice, but they're also more complicated than being one participant in an employer's 401(k). With a solo 401(k), you are the one in charge of completing all the sophisticated paperwork involved in establishing an employer-sponsored retirement plan and you're responsible for any costs incurred by working with the financial institution.

Moreover, there are some IRS reporting requirements that accompany running a solo 401(k) plan, once your account balance exceeds certain levels. Your financial provider should walk you through this process and give you the help you need, but it's still something you'll want to do carefully in order to make sure you comply with all the rules and regulations surrounding employer-sponsored retirement plans.

Be smart with your 401(k)

Whether you have access to a 401(k) from your employer or have to set up a solo 401(k) on your own, saving for retirement can be a lot easier when you have a 401(k) account in your toolbox.

With their unique combination of tax benefits, investment flexibility, generous contribution limits, and employer support, opening a 401(k) can be the best move available in setting yourself up for a financially secure retirement.

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