By Paul R. Ruedi, CFP®
Most people are typically introduced to a 401(k) plan, a mysterious combination of numbers and letters, when their employer hands them an employee benefit sheet. There may be little to no explanation of their options, and they are then left to make important investing and retirement planning choices. This may be done with absolutely no financial education or background on the decisions being made.
If you are just now learning that you need to pay attention to your 401)k) plan, consider whether or not you know how much you are contributing, whether or not you are getting your full employer match (if your company offers that benefit) and if you know how much of your money is being invested. It's not uncommon if you can't answer all of these questions or have made mistakes in your 401(k) plan. Our educational system does not provide any background information on 401(k) plans. (For more, see: The Basics of a 401(k) Retirement Plan.)
To help you decode it, here is a simple explanation of five important features of a 401(k) plan that employees need to be aware of:
1. Employee Contribution
The employee contribution to your 401(k) is the amount you personally are contributing to the 401(k) plan. You are given the option of how much you would like to contribute, usually as a percentage of your income, and that amount is automatically deducted from you paycheck and placed in your 401(k) account. It is important to be aware of how much you are contributing for many reasons, the most important of which is to make sure you are contributing enough to take advantage of an employer match.
2. Employer Contribution and Matching
The employer contribution is how much your employer is contributing to the plan on your behalf. Some employers automatically contribute a certain percentage of their employees’ income, while others offer to “match” employee contributions up to a certain amount to incentivize people to save for retirement. There are different types of matching schemes. Some will match “dollar for dollar,” so if you put in 3%, your employer puts in 3%. Others will match a percentage of contributions. For example, if your employer matches 50% and you contribute 6% of your salary, your employer will contribute 3% of your salary. I strongly recommend people contribute enough to their 401(k) plans to maximize the employer match.
An important feature of employer contributions is the vesting period. Vesting is a term for how fast ownership of the contributions your employer made transfer to you, the employee. Many employers designate their contributions to 401(k) plans as 100% vested immediately - the employee owns them right away and if for some reason the employee changes jobs or needs to move money from that plan, the money is 100% theirs.
But sometimes in order to incentive employees to stick around, companies will have their contributions vest over a period of time. This will often take the form of a graded vesting schedule, where a certain percentage (20% for example) vests each year. Or it may take the form of a “cliff,” where you need to wait a certain number of years to be 100% vested, otherwise you don’t receive any of the employer-made contributions to your 401(k).
4. Investment Options
401(k) plans usually provide you with plenty of options to invest your money. The options depend on the employer but most often include a diverse array of 10 - 20 investment funds covering various asset classes from the highest risk stock funds to the lowest risk bond and money market funds. (For more, see: Understanding 401(k)s and All Their Benefits.)
Do not just select every option or choose from the options randomly. Do your research and use your investment options to build a portfolio that is low-cost, diversified and has the appropriate asset allocation for you as an investor. The plan may provide you with a lot of information, but you may have to do some digging yourself by looking up the names of the investment funds or ticker symbols on google.com or finance.yahoo.com. Most people do not have the expertise to build an investment portfolio that is right for them. Do not be afraid to seek help.
5. Roth vs. Traditional
You will be given the option to designate your contributions to a "traditional” or Roth 401(k). Traditional 401(k) contributions are pretax - the amount you contribute can be deducted on your income taxes, lowering you tax bill. Contributions then grow tax deferred but when it comes time to withdraw down the road, the withdrawals are taxed at your ordinary income tax rates.
Roth contributions are made with after-tax dollars. Your Roth contributions cannot be deducted from your taxable income, but your contributions grow tax deferred and can ultimately be withdrawn tax free provided you follow all the rules.
Don’t get too caught up analyzing the Roth versus traditional decision and avoid investing altogether while you do. This decision is really a matter of deciding if you want to pay taxes now or later, which is driven by whether your tax rate will be higher or lower in the future than it is now. That involves making some predictions about the future and is not a perfect science, so don’t over analyze this decision and lose sight of the bigger picture.
Understand Options to Maximize Benefits
Investing in a 401(k) is a great first step towards funding your dream retirement. But there are several moving parts that you need to be aware of to make sure you maximize the potential benefits of a 401(k). Simple tweaks like increasing your contribution to maximize your employer match can be made in minutes but can have a huge impact over the course of your life. Do your research, understand how much you and your employer are contributing and how it is being invested. Use your investment options to build a portfolio that is right for you. You will be on your way to your dream retirement. (For related reading, see: Top 10 Mistakes to Avoid on Your 401(k).)
This article was originally published on Investopedia.