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Class of 2016, Here’s How to Set Up Your First 401(k)

July 20, 2016
401(k), Investing
Class of 2016, Here’s How to Set up Your First 401(k)
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401… what?

No shame if that’s the first thought that comes to mind when presented with this benefit at your first job post-graduation. It’s named after a section of the tax code, and the IRS could’ve saved us all a lot of grief by calling it what it is: an employer-sponsored retirement savings account.

The beauty of a 401(k) — and why you should listen up when you get to this part of your job orientation — is that it allows you to send money directly from your paycheck into that investment account, before taxes are taken out. Better still, at least a portion of those contributions are likely to be matched by your company. (Another name for that: free money.)

If you’re offered one of these accounts, you should take it. Getting the retirement-saving ball rolling not only puts time on your side — the earlier you start, the more quickly you’ll start to build wealth — it also begins the process of turning saving into a habit. On the flip side, the longer you put it off… the longer you’ll put it off.

The basics of a 401(k)

There are a few things you need to know about this kind of account. Your contributions are earmarked for retirement, and because they’re made pre-tax, the IRS holds them with a tight grip. In most cases, you’ll owe a 10% penalty and income taxes if you pull the money out before age 59½. But if you make it to that finish line, you’ll have a pot of money that has grown tax-deferred; when you make withdrawals, called distributions, that money will then be taxed as income.

Don’t let that penalty scare you, says Brian McCann, a certified financial planner and founder of Bootstrap Capital in San Francisco. “One fear people have is that they’ll need the money. That’s a valid fear, but if your company offers a match and you’ve invested up to that, unless your tax rate plus penalties is above 50%, you’ll still walk away ahead” if you have to tap the account early.

That doesn’t mean you should dip into the account, and it assumes your employer’s matching dollars are vested, which means the money is yours, even if you leave your job. Some companies offer their match on a vesting schedule that requires you to stay a certain number of years to keep that money. (Money you contribute from your paycheck is always yours; if you leave a job, you can roll your 401(k) over to an IRA, or your next employer may allow you to roll the money into a 401(k) plan there.)

A standard employer match is 50% or 100% of your contributions, up to a limit, often 3% to 6% of your salary.

Deciding how much to contribute

You may feel like you have a lot of drains on your budget: Student loans, for example, plus the burden of managing monthly expenses on your own for what may be the first time. You now know why your parents stressed turning out the light when you left a room.

But a 401(k) contribution should be factored into your budget just like any other expense, and in most cases, it should be prioritized before paying extra toward student loans, McCann says.

“If you can earn more investing than you’re paying in interest on your loans, make minimum payments on the loan, then max out your employer match to your 401(k). An employer match is a 100% return, and you don’t get that anywhere, so it’s silly not to take it.”

So that’s the first guideline. Once you’ve captured that match, you can direct additional attention toward your student loans, or you can open an IRA and continue investing there, where you’ll have a wider investment selection, potentially at a lower cost. (An IRA can be your first stop if your employer doesn’t offer a retirement plan.)

» Learn more: How to save for retirement

Choosing your investments

That baby face isn’t the only benefit to being young: You can afford to take more investment risk, which means you can put the bulk of your money toward stock or equity funds.

Funds hold a basket of investments, so you’re not selecting a single stock or bond, but rather hundreds of them in a certain category. A U.S. large-cap fund, for example, will hold the stock of large companies in — you guessed it — the U.S.

» Learn more: Our guide to investing 101

In general, 401(k)s offer a tight set of investment options, maybe 10 to 20 fund choices. Some will have high expense ratios, which is another term for the annual fee charged to investors by a mutual fund. These can range from below 0.10% to 1% or more: A 0.50% expense ratio means you’ll pay $5 for every $1,000 you invest.

Your goal is to keep costs low, which often means selecting index funds and exchange-traded funds over actively managed mutual funds. The former track an index — say, the S&P 500 — without the oversight of a professional manager, which means they typically cost less. Then you want to diversify not just by industry, but globally, says McCann.

And if all of this is making you regret all those skipped economics classes? Your 401(k) likely offers a target-date fund option, which may have a higher expense ratio but is automatically diversified and designed to rebalance to take less risk as you age. Select the one with the year in the name that most closely matches your estimated retirement date, or mimic that fund’s holdings to build your own portfolio.

Finally, work up to saving more. The easiest way to do that: Increase your retirement contribution each time you get a raise.

» How much should you save? Consult NerdWallet’s 401(k) calculator 

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: [email protected] Twitter: @arioshea.

This article was written by NerdWallet and was originally published by USA Today College.