15 Things to Know Before Opening Your First 401(k)

Many people use a 401(k) to save for retirement. This is often a smart financial move. But before you begin making 401(k) contributions for the first time, you need to learn the details about exactly how this account works and what it can -- and cannot -- do for you.

Not sure where to start? Here are 15 things to know before you make your first deposit into a 401(k) plan.

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There are actually two different kinds of 401(k) plans: a traditional account and a Roth account.

A traditional 401(k) allows for you to make pre-tax contributions. However, as a retiree, you will pay taxes when you take distributions. A Roth works the opposite way, deferring the tax savings until you are a retiree. It's important to understand how both work.

ALSO READ: Roth IRA vs. Roth 401(k): Which Is Best for You?

A growing number of employers offer both a traditional and a Roth 401(k). But not every company does. You will only get the chance to choose between them if your employers make this option available to you.

If your company doesn't give you a choice, a traditional 401(k) will likely be your only option. If you want to invest in a Roth, you'd need to open an additional retirement account elsewhere with a brokerage firm.

When you invest in a 401(k), you do not get to decide what brokerage firm you open your account with. Your employer will offer a 401(k) plan administered by a company of its choosing. You can either participate or not, which means you have much less flexibility in where your retirement dollars go.

ALSO READ: 3 Surprising Downsides to Investing in Your 401(k)

The good news is, getting started investing in a 401(k) is very simple because your employer sets up the retirement plan. All you need to do is ask HR about getting the paperwork. In many cases, it's just a matter of filling out a few simple forms, which you can usually do online.

Depending on the company that you work for, you may not have to do anything to start investing in your 401(k). That's because some businesses automatically enroll you and begin making contributions from your paychecks on your behalf unless you opt out of doing so.

You may want to change your contribution amount even if your employer does this, but it should take very little effort to do that once your employer has got you set up.

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Many employers who offer 401(k) plans provide matching contributions. In other words, when you put money in, your employer puts some in, too.

The rules work differently depending on your company. For example, some companies match 50% of contributions, and others 100%. And the match is usually capped at a percentage of your salary.

It is absolutely worth learning how your company match works and making sure you contribute enough to earn the full amount. Otherwise, you are passing up free money.

ALSO READ: How to Get the Most Out of Your 401(k) Company Match

When you contribute to a 401(k), your contribution is made with pre-tax dollars. This means your take-home income is not reduced by the full amount you contribute. Your savings depends on your tax bracket. If you're in the 22% tax bracket, contributing $1,000 could save you as much as $220 in taxes, so that contribution would cost you only $780.

There is an annual contribution limit to be aware of. In 2022, it's $20,500 in 2022, and those 50 and over can make an additional $6,500 catch-up contribution for a total of $27,000 in deductible contributions.

When you contribute to an eligible retirement plan, you may be able to claim the Saver's Credit. This is worth up to $2,000. A 401(k) is an eligible account, so you can save substantially on your taxes if you are eligible for this credit based on your income. You'll absolutely want to invest the full amount necessary to max out this credit and get this added help from Uncle Sam.

ALSO READ: IRS Is Rewarding Retirement Savers With Up to $2,000 -- Are You Eligible?

When your employer matches your contributions, this does not count toward your $20,500 or your $27,000 contribution limit. There is an annual limit on total contributions, but it is much higher. Total contributions in 2022 including yours and your employer's cannot exceed $61,000, or $67,500 if you are over 50.

Putting money into your 401(k) is only the first step. Many people do not realize they also have to pick what assets to buy with it. This is crucial because building a diversified portfolio of investments will help your money grow while minimizing risk.

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When you open an IRA with a brokerage firm, you can invest in almost anything you want that the brokerage offers. That's not the case with a 401(k). You may have around a dozen or fewer funds to choose from within your workplace plan. While this makes investing easier, it does limit your options.

ALSO READ: 5 Investment Strategies to Maximize Your 401(k)

Although a 401(k) can be a simple and easy way to invest for retirement, this could come at a cost. Your plan may charge administrative fees. And the investments that are available within the 401(k) could potentially have higher expense ratios than other similar options that your account doesn't provide access to.

If investing within your 401(k) turns out to be expensive, you may want to limit your contributions to the amount needed to earn your employer match and then invest in other tax-advantaged retirement plans.

A 401(k) does limit your ability to access your investment dollars. In most cases, you will have to wait to begin making withdrawals until you are 59 1/2. If you start taking out money sooner without falling into an exception, you would be hit with a 10% penalty.

ALSO READ: Guide to Taking Money Out of Your 401(k)

Although early withdrawals are off the table without IRS fees, some employers allow you to borrow against your 401(k). You would have to pay the loan back with interest, but would be paying yourself.

There are downsides to this option, though, including the fact that your loan will become a withdrawal (and trigger the resulting penalties) if you don't repay it as planned. So, you should try to steer clear of borrowing against your 401(k) except in financial emergencies.

Finally, you can make deductible contributions to a 401(k) even if you are a high earner. This is not necessarily true with traditional and Roth IRAs as eligibility for these can depend on earnings. If you make a lot of money, contributing to your 401(k) could be your best way to get tax breaks for retirement savings.

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Now that you know the details, you should be ready to start investing in a 401(k) if you have access to one.

Putting at least enough into this account to earn your employer match is a no-brainer. You can decide beyond that whether to continue deposits into your 401(k) plan or pick another investment account that's a better fit for your money.

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