401K Beginner's Guide
Finance,  Retirement

The Beginner’s Guide To A 401K

July 15, 2021 /
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As the title suggests, this is beginner’s guide to understanding a 401K. I felt the need to create this post because I know so many who don’t take advantage of this easy way to save for retirement, something I’ve been guilty of, myself.

I’ve helped handfuls of other people with their 401K’s and this seems to be a norm. Besides saying “You could/should sign up for this”, there isn’t much, if any, guidance offered. No one says “This is what it means if you DON’T take this”.

This is for those who may be new to the “adult world”, or for those that don’t feel like they have a good understanding of their 401K and retirement benefits. This is only focusing on 401K’s, as discussing all retirement options would make this post way too long! And, being a beginner’s guide, I don’t want people to feel overwhelmed. My hope is that this post will provide awareness and clarity around this one key retirement vehicle.

But, first things first, and I want this to be very clear up front: The following should not be construed as investing advice. Speak to a financial professional for specific financial advice. I do not give tax or legal advice. These are just opinions based on my experience and not any guarantees to make you rich. See my disclosure policy.

My 401K Journey

I know it’s hard when you’re young to be concerned about saving for retirement. You just started your career, right, and now you need to prepare for when you leave it? It’s a little crazy, I get that. I remember my own lack of care when I first started my career. I was more stoked that I would be able to take a vacation and still get paid! But, not paying attention to the rest of my benefits- namely, retirement- is one of my biggest financial regrets.

If your workplace is like mine was, there was very little direction given about retirement accounts. When I started my job, they told me the benefits I was eligible for, including retirement benefits, but there wasn’t much guidance beyond that. No one really ever sat me down and walked me through the “why” I should have a 401K, and the benefits I’d be giving up by not doing it. Not to mention I had no guidance in how I should be invested in it. I was shown the investment options within the 401K, but what exactly they signified wasn’t explained.

What was even worse, when I did finally pick a certain investment strategy, it was months before I realized that they hadn’t processed my paperwork properly and I’d been invested in a fund that was basically a glorified CD! I simply had no idea what I was looking at or what I was doing with 401K.

So, here are some questions you might have if you’re starting in your new job and they’ve told you that you get a 401K.

What is a 401K?

A 401K is, in very simple terms, is a savings account for retirement that you can’t touch until you retire*. You put money in, you can invest it, and it will be there for you when you retire, presumably at 59 1/2. This is not a pension. This is money you put in, and it’s all yours.

401K’s are typically used as a “pre-tax” account. This means that the money you put in from your paycheck was not taxed. You will only get taxed on this money when you pull it out in retirement, whenever that may be. Your current tax bill is lower because you chose to contribute to your 401K.

Employers typically have certain mutual funds or other stocks available to you in your 401K. You can invest in these with the idea that this will grow your money. You could choose to keep it in cash, but that wouldn’t be wise.

*Technically, you can pull money out of your 401K, but expect to lose at least a third of the balance. Because you’re taking money out before retirement age, you pay a 10% penalty, plus all the tax you didn’t already pay on that money, due all at once.

What’s “the match”?

This is the best part of having a 401k if you’re lucky enough to work at a place with a match. It’s essentially “free” money!

“The match” is when your employer also contributes a certain amount to your 401K, based on your own contributions. If they say they’ll match half up to the first 6%, that means that if you contribute 6%, your employer will add an additional 3% to your account. If you only contributed 3%, they’d contribute 1.5%.

So, if you’re making sure that you get the highest match, instead of just 6% of your salary going into your 401K, it’s actually receiving 9%! Sounds pretty good, right?

Using the example of a $40,000 salary, you’re contributing 6% ($92), and the company matching half, your employer is adding $46 to your retirement per paycheck. So, in total, there is $138 going into your 401K per paycheck!

Sadly, I know plenty of people that are guilty of not taking advantage of this benefit. Don’t be one of them!

In fact, it’s been shown that those that make less than $40,000 per year, an incredible 42% do not take their full match! And those under 30 are twice as likely to not take advantage of this benefit.

Just because that extra money doesn’t go in your pocket now does not mean you should be turning down an extra 3% of your paycheck. That’s just… not smart.

To put this a different way, if you don’t take your full 3% match, that’s $1,200 a year that your company is willing to give you that you’re not taking. If you never get another raise for 40 years, that’s $48,000 that you said “no” to. If you had invested that 3% every paycheck in your retirement, you’re literally giving up hundreds of thousands of dollars because you’re missing out on the investment gains and compounding. Sounds like a lot to me.

What’s my contribution?

Also known as your savings rate, your contribution is how much you are willing to set aside each paycheck to go into your retirement account. Your contribution amount can be whatever you want it to be! It could be 1%, 3%, 6%, whatever you decide. The higher, the better!

There is guidance out there that you should be saving 10% of your paycheck for retirement. You may also hear 15%. I’ll just repeat: the higher, the better. It’s up to you.

If you’re young and single, contribute a higher amount. I’d also say that if you’re starting later, you should definitely contribute a higher amount. This is a beginner’s guide so you can start with baby steps. 🙂

Also, keep in mind also how much YOU need to contribute in order to get your employer to give you the maximum match.

So let’s talk about what it means to contribute, and we’ll use 6% as an example. If you’re earning $40,000 annually and get paid bi-weekly (so 26 times per year), your gross paycheck is $1,538 (I’m rounding). If you’re setting aside 6% in your 401K, that’s $92 per paycheck.

Don’t forget that this contribution can also lower your tax liability if you’re investing in a traditional 401K. Using the example above, your taxes would be based on the $1,538 less the $92. Since your paycheck is “after tax” money, you’re not giving up $92, it’s probably more like $70. Not bad, really.

How much can I contribute each year?

You may not have actually known that there is a limit to how much you can save in your 401K each year, but there is. The limits change every year. You can contribute up to 75% of your paycheck or up to the contribution limits, whichever is less.

For 2021, you’re allowed to contribute up to $19,500 (check irs.gov for current limits). You’re also allowed “catch up” contributions if you’re over 50, currently at $6,500.

If you over-contribute, you have to take that money back out and get taxed on it at tax time.

What do I do with the money I contribute?

You have to remember to invest your money once it’s in your account!

There are instances in which people thought that simply contributing to their retirement accounts would ensure that it was earning interest. What they didn’t realize is that they had to tell that money what to do once it was in the account. Otherwise, it will just sit in cash, and would actually lose its value over time!

All the different investing options out there will be a topic for another post, but I’ll touch on mutual funds briefly because they’re almost exclusively what you’ll see offered in a 401K.

Mutual funds are a single fund that you can invest in, but those mutual funds own pieces of multiple companies. So, when you invest in a mutual fund, you’re actually investing in a variety of different companies. Again, the idea is that your money will grow by investing in these.

How to evaluate how many or which mutual funds to invest in will also be a topic for a different post. You could also read this beginner’s guide to investing.

What’s a Roth 401K?

Your employer may not even offer this, but you should ask them if they do. I didn’t know I had this option for years because, again, we got zero guidance.

A Roth 401K is like a Roth IRA: contributions are post-tax, and investment gains are not taxed. This means that the money you’ve made from investing won’t be taxed when you withdraw it in retirement!

The difference between the Roth IRA and the Roth 401k is that a Roth 401K has the same contribution limits as a 401K while the Roth IRA limits are much, much lower.

Why would you want to contribute to a Roth 401K? Roth accounts are attractive because your withdrawals are tax-free. The not attractive part: contributions are after you have already paid tax on that money, so you don’t have the advtange of reduced tax now.

You don’t have to use the Roth option, but it is something to think about it. You could consult a financial advisor, but it’s not necessary. They would lay out the pros and cons, but you could probably just decide on your own when you get more comfortable with investments and create a retirement strategy.

What if I’m not being offered a 401K, I’m being offered something called a 403B?

And I said I was going to only focus on 401K’s… This is a good question, and it might be one some of you need to ask. The reason I’m mentioning it is because a 403B functions the same as a 401K. Why it has a different name is because it behaves differently for your employer. You’ll typically see 403B’s offered at tax-exempt or non-profit institutions like schools or hospitals.

Like the 401K, the 403B may also have a Roth option. Just ask if you’re unsure and are interested in using that option.

See this article from HerMoney (a Jean Chatzky company) to get a brief overview of these accounts.

Closing Thoughts

Contributing to a 401K is a great way to get started on your retirement. Even if you don’t get a match, you should still be taking advantage of the automatic withdrawls from your paycheck. And, when you have your investment strategy in place, you could be earning on the money you still contribute.

I hope you found my beginner’s guide to 401K’s helpful. If you have any questions beyond what I’ve addressed here, contact me or leave a comment below!

RELATED

See best practices for your 401K

Check out this post if you’re a beginner investor

See how to maximize one of your other employee benefits, the HSA

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