If you were like me after graduating from college and getting your first real job, you always heard your parents or other colleagues talk about making sure you contribute to a 401k (or a 403b if working in public sector, charitable organization, etc.) otherwise you will not retire.
In some cases, I know others who’d never heard of a 401k until the paperwork showed up for enrolling. Contributing to this type of account early and often over the course of your working career is crucial to retiring.
Below are some tips and pointers to use when starting in your employer’s retirement plan or even if you switched to a new job:
1. Not Getting Your Full Employer Match:
The biggest box to check off when starting to contribute to an employer plan is to ensure you are getting the full match offered, usually denoted in percentages of salary. Depending on your employer you may be able to start contributing once you are over age 21, after 90 days of working there, or 3-6 months after hire based on entry dates.
Taking advantage of it is essentially getting “free money” or can even be described as “100% return” on top of what you defer. Employers must provide some sort of match for the plan to be compliant with ERISA and meet benefit testing to stay a qualified plan. However, based on your employer’s plan, the wording and match percent can vary.
For example, employers could match 100% of your contribution up to 3-4% of your salary, or the match will be 100% of first 3% then 50% of next 2-3% of salary, etc. with the percentages being higher or lower based on plan rules. Some plans may delay matching until after you have worked there a year so always refer to plan documents if it is not immediate upon entry.
You can also consult your co-workers who participate in the plan or HR to make sure you are contributing the right percentage to get the full match. Some financial sites may suggest not contributing to your 401k if you have debt (besides a mortgage) to pay that down, but do not make that mistake and miss out on doubling your money at the very least. This just makes you must play catch up down the road when your situation gets more complex and less time to retirement.
Putting in at least the amount to get the full match also automates your savings since it comes out of your paycheck directly and if cash flow allows you can increase your contribution as needed.
2. Not Monitoring Your Tax Bracket to Choose Pre-Tax or Roth Contributions:
When determining what percentage of salary to contribute to your employer’s plan it may prompt you to defer your salary either as pre-tax, Roth, or both. Contributing pre-tax will reduce your gross income being taxed now but when you start withdrawing in retirement you will pay those deferred taxes back, whereas Roth is contributed after-tax and withdrawals in retirement result in no taxes even on the earnings. You can usually save $0.40 on taxes for every dollar contributed pre-tax.
If you are younger and just starting in the work force like myself Roth contributions into your 401k may make more sense to capitalize on the tax-free money later on. However, as you progress in your career, make more income, and see changes in your tax filing status and tax bracket, etc. pre-tax contributions will be more beneficial. These can get you into a lower tax bracket if you are on the verge of income crossing into a higher threshold or if large bonuses, stock payouts, etc. are expected.
You can contribute to both simultaneously, but it is still subjected to the IRS max of $20,500 combined if under 50 years old (an additional catch-up of $6,500 allowed in year you turn 50 and onwards).
You can always review your tax return to see your tax brackets and adjust as necessary or work with an accountant or financial advisor to help in determining a contribution strategy.
3. Not Adding or Updating Beneficiaries:
When starting in your employer’s plan it may prompt you to name beneficiaries.
These are who you would want the account funds to go in case of your passing. You can name the person, charity, or trust primary or contingent, primary being immediately upon passing or contingent if something happens to your primary beneficiary(s). These can change as life changes as when you are starting out you may name a sibling or parent.
Then as you get married and have children, you will want to update it to add them instead. Doing this serves as a will substitute if you do not have estate documents in place for the account to avoid probate.
If you do have estate documents in place you want to make sure the beneficiaries match how the assets flow in your will (typically all to surviving spouse, but if not surviving, to children equally or a living trust/trust under will). Always check with your estate attorney to make sure these match up across all accounts.
One thing to beware of is if your employer moves the retirement plan to a new provider that your beneficiary designations may not get carried over with it after the blackout period so make sure you set them back up in that event.
4. Not Knowing Your Employer’s Vesting Schedule:
As mentioned earlier, your employer will contribute to your retirement plan based on how much you contribute to a certain percentage. However, depending on the plan rules, you may not be vested in that match until a certain number of years employed there are met.
Vesting (also denoted in percentages) in a 401k plan means how much of the money is yours and that you can take with you or rollover upon leaving them. All your contributions from payroll will always be fully vested. The match your employer puts in can be fully/100% vested if the plan allows or they may subject it to a vesting schedule. For example, the plan may be subject to a 5-year vesting schedule where 20% of the employer match becomes vested each year until you reach 5 years of employment. They are used as a retention tool to try and prevent turnover. Depending on plan rules death may accelerate the vesting percentage but it is not required.
Vesting mainly affects you if you go to a new job and want to rollover your prior 401k into an IRA or to the new employer’s plan. Using the previous scenario, if you only worked at the old job 3 years then you roll it over, the old employer can keep 40% of the amount they matched you on.
You can always leave your old plan alone, but you may want to check if it will be forced out based on dollar amount, the old plan has higher administrative fees, etc. If you change jobs as frequently as newer members of the workforce have been then you may want to simplify your financial accounts by consolidating them after each change.
5. Not Investing Based on Your Time Horizon/Risk Tolerance:
As opposed to defined benefit plans like pensions where the investment risk/performance is on the employer, a 401k plan places that responsibility on you, the employee, to pick where your contributions go to. They must provide a minimum amount of fund options ranging from target-date retirement funds to bond funds, multi-cap funds, US, index funds, international funds, and sometimes company common stock.
Target-date funds provide the advantage of putting your investing on autopilot since they start off with high stock percentages then get gradually less stock as you get closer to retirement. They usually come in 5-year intervals so if going that route pick the closest one to your desired retirement age or when you turn age 65. Some 401k custodians offer an auto-rebalance feature that sort of invests for you and rebalances on a monthly or quarterly basis. It will answer some questions for it to decide asset mix and risk tolerance and it does the rest. This could have you end up invested contributions in almost all of the plan’s funds and which could result in overlap of their underlying holdings.
But if you like to pick your own funds, being younger allows you take have higher risk and stock exposure in the equity funds since time is on your side. However, without checking in every so often as your career progresses, you may be too risky and cannot afford as much risk or withstand a possible market correction. You also want to coordinate how you invest your 401k with how your other investment accounts (IRA, Roth IRA, brokerage/TOD) and decide to take on more stock in one and have one be more conservative.
If you have any questions about your 401k or retirement plan, contact us today.
