Advertiser Disclosure

Dear WalletFinance: What is a 401(k) and How Do I Invest in One?

Investing

by Susan Lyon

Dear WalletFinance is our running investing column devoted to answering to your most pressing investing & finance questions.  Got a money question?  Write to us at support@nerdwallet.com.

Dear @WalletFinance:

My friends have been talking about their 401(k)s a lot recently, and it’s stressing me out. First of all, do I really need a 401(k) and if so, why? If I get one, what’s the smartest way to invest the money I’m collecting in it?

Sincerely,

Fearful Funder

 

Dear Fearful Funder,

Don’t be afraid – NerdWallet is here to help!  We’re proud of you for taking the initiative to consider opening your first 401(k) account.

A 401(k) is a simply a retirement plan offered by your employer, but you have to elect to sign up for it or it won’t kick into gear.  It’s a tax-deferred account; that means it allows you to invest pre-tax money in mutual funds to save and invest for retirement, allowing your money to grow without being taxed at the same time.  Not all employers offer them, but when they do – and particularly when they match the money you put in – it’s a smart tool to take advantage of.

Why Tax Deferral Is Your Friend

A tax-advantaged account like a 401(k) is a great thing, for this simple reason: the benefits of tax deferral are huge.  This chart from ING shows the beauty of tax deferral:

 

Because of compound interest, an account that is left to grow untaxed will give you more money in the end – even if the money that eventually comes out is taxed at the point of withdrawal – than an account that is taxed all the way along.

Step One: Opt in.

First, figure out if your employer has a 401(k) offering. Don’t be shy about asking if you don’t know; it’s a very common question and every employer expects to get asked about it at some point.  If so, sign up: don’t forget to turn in the paperwork!  It’s quick and worthwhile.

You must pick upfront what percent of your pre-tax paycheck goes into the account, with typical percentages ranging from 2 to 10% depending on what you can afford to save.  Come payday, part of the paycheck will then go automatically into your 401(k) account.

Step Two: Determine your asset allocation and what to invest in.

You now have options of what to do with the money you’re saving up in the account.  Companies usually offer a variety of accounts that give different weights to stocks, bonds, money markets and the company’s own stock.  In a way, doing this is easier than figuring out what to invest in from scratch because your options are a lot more limited – the plan your company uses probably has already limited down the options quite a bit for you, and usually you can only invest in funds – a safer bet than individual company stock.

That said, these funds aren’t always the ones you would pick if you could have total say – so be sure to pick carefully.  Generally, 401(k) funds favor “safe” investments like Treasury bonds or money markets.  But if you are a young investor and don’t plan to retire for quite some time, you know that time is on your side.  You can afford to take advantage of the higher risk, higher returns tradeoff.  This means you should try to pick the stock-heavier funds available for investing in, while still being sure to diversify between market cap, geography, value versus growth, etc.

(Forgot what the major asset classes are?  Check out our major asset classes & asset allocation introductory post to help guide your investing.)

Step Three: Sit Back and Relax.  Rebalance Occasionally.

Don’t you love this part?  Watch your money grow, and monitor it every few months to make sure it’s heading in a direction you like.  There will be periods of time when you can move your money around between funds and asset classes, a.k.a. rebalancing your account(s).

Step Four: Leaving Your Old Job?  Don’t Forget Your Stash of Cash.

Whether you leave a job on good terms or bad, you’re entitled to all the money you’ve saved up in your 401(k) so it’s worth the potential awkwardness to make sure you get it where you want it.  Otherwise, you’re literally leaving hard-earned money on the table.

You basically have these 3 main 401(k) rollover options – we recommend the first:

  • Rollover your 401(k) to an IRA, so you don’t have to pay tax on it.  If you struggle to keep track of many accounts, you can roll all past jobs’ 401(k)s into the same IRA as you go, so you only have one big pot of money to deal with.
  • Keep your 401(k) with the former employer’s plan, if they allow it.  However, employer managed plans generally have higher fees than IRAs so it’s smart to roll out as soon as possible.  Some companies allow you to keep your plan with them active even once you leave, but it means you have yet another account to keep track of over time.
  • Cash out your 401(k), though we don’t recommend it.  We think this is the least desirable option because you’ll lose a lot of the saved money from taxes and penalties.  Don’t do it unless you desperately need the money now.

Of course, if you forget about your 401(k) and then remember it again later, it’s kind of like finding hidden treasure – hundreds or even thousands of dollars you’d forgotten about!  But ideally, you won’t forget about it, and as soon as you leave one job for another you’ll file the necessary paperwork (the HR rep should have it) to rollover your 401(k).

Frequently Asked Questions About 401(k) Plans:

Q: “Can I have a 401(k) if I don’t have a job or if my employer doesn’t sponsor one?”

  • A: No, but you can use other tax-savvy mechanisms to save and invest for retirement.  NerdWallet provides a comparison chart of different types of IRAs here.

Q: “If I already have my max 401(k) contributions set up, am I good?  Do I have to save more?”

  • A: It’s up to you, but saving more is always better than saving less.  You should at very least be sure to have saved up several months’ worth of emergency funds in a rainy day fund, for one thing.  You should also estimate how much money you’ll need saved up for use prior to your retirement, for typical expenses such as housing, marriage, college tuition, and other large expenses.  A 401(k) cannot be used for these things before retirement age so an alternate account should be opened for savings that will be needed in the medium term.

A Pot of Gold at the End of the Retirement Rainbow

In an age when the future of social security is incredibly uncertain, retirees are right to be worried about whether their financial plans will last them all the way through retirement.  It’s smarter than ever to start saving and investing at a younger age, and the numbers show that the earlier you start, the more your money grows.

Can’t you just picture the future, and how happy your 75-year-old self will be one day, looking at how much your savings have grown over the years?  Thank yourself in advance.

Sincerely,

@WalletFinance

Want to learn more?  Start by reading our inaugural investing 101 posts, A Framework For Investing and Asset Classes and Asset Allocation.