These crucial questions should be considered before enrolling in a 401(k).
If your workplace offers a 401(k), count yourself fortunate. Nearly half of U.S. employees lack access to any retirement plan, increasing the likelihood they won't save adequately for a secure retirement.
To fully benefit from your 401(k), it's essential to grasp its workings. Each employer's rules and options vary—some plans are more advantageous than others. Nonetheless, the overall advantages of having a retirement plan are significant, so don't overlook yours even if it seems subpar.
Here are some important questions to ask prior to signing up.
When can I begin contributing?
The sooner, the better. Many employers automatically enroll eligible employees in their 401(k) plans. Others require you to actively enroll, and some may have a waiting period of up to a year. If there's a delay for your plan, consider setting up an IRA or Roth IRA to contribute in the meantime.
What is the contribution limit?
While federal law establishes a cap on annual contributions, employers can impose lower limits. If your plan includes automatic enrollment, you often still have the choice to contribute more than the preset amount, generally around 3 percent. Aim to save at least 10 percent of your income for retirement—15 to 20 percent is preferable, especially if you begin saving after age 35. If you can’t reach that target, contribute what you can and gradually increase it with each pay raise.
What’s the employer match?
Most 401(k) plans provide matching contributions from your employer, giving you free money. According to Aon Hewitt, the most common match is dollar-for-dollar up to 6 percent of your salary. Make sure to contribute enough to receive the full match.
Even if there isn’t a match, contributing is still wise. Your contributions can reduce your tax burden and potentially grow tax-deferred over time. With an average annual return of 8 percent, every $100 you invest could grow to $1,000 in 30 years and $2,000 in 40 years.
When will I be vested?
A reader once hesitated to contribute to her 401(k) due to a two-year vesting period, fearing she’d lose her investment if she left. Unfortunately, she misunderstood vesting.
“Vesting” refers to your right to retain employer contributions. Some companies allow you to keep these contributions right away, while others require a certain employment duration. Your own contributions, however, are always yours. Although your investments may fluctuate in value, they cannot be taken away. Only employer contributions may have vesting conditions, meaning you must stay with the company for a specified time to keep the match. For instance, with a five-year vesting schedule, you might retain 20 percent after one year, 40 percent after two years, and so forth until you reach full ownership after five years.
Is a Roth 401(k) available?
The tax advantages of contributing to a 401(k) are compelling, but some plans allow after-tax contributions through a Roth 401(k). You won’t receive an upfront tax break, but withdrawals in retirement are tax-free.
Having regular and Roth accounts can provide flexibility in managing your taxes during retirement. If you're young or anticipate a higher tax bracket later, contributing to a Roth 401(k) is often a wise choice.
What are the investment option costs?
Minimizing investment costs is crucial for maximizing your returns. However, understanding the costs associated with your 401(k) can be challenging. Regulations intended to enhance cost transparency haven't been as effective as expected.
Nevertheless, the plan provider should supply an expense ratio for each investment option, indicating how much of your return is deducted for annual expenses like management fees. Higher costs generally do not lead to better returns—in fact, it's often the opposite. Index funds that aim to match the market can be your best bet.
If your options are all costly, with expense ratios of 1 percent or more, continue investing through the plan but ask your employer to explore switching to a more affordable provider.
Where can I find impartial advice?
When inquiring about investment advice for your plan, specify that you want a fiduciary who will act in your best interest. Alternatively, you can explore digital advice services that recommend investments for your 401(k), such as FutureAdvisor or Smart401k, or those that can manage your plan for you, like Blooom.
