Investment 101: How to Start a 401(k)
To encourage people to save for retirement, the government offers a number of tax advantages for contributing to special retirement plans, including 401(k) plans, which can be offered by for-profit companies. Knowing how your 401(k) plan functions helps you make better decisions about how much you want to contribute and how you want to invest the money in the account.
Who Can Contribute to a 401(k)
Just because you want to save for retirement doesn't mean you're going to be allowed to stash your cash in a 401(k) plan. You must work for an employer who offers a 401(k) plan and meet the eligibility requirements set by your employer to participate. For example, plans can exclude you from participating if you're under 21 or have been with the company for less than a year.
Even if you're not able to put money in a 401(k), you're not out of luck completely. "If your employer does not offer a 401(k) plan, you can elect to fund your own Individual Retirement Account, which may be tax deductible...or a Roth IRA (not tax deductible but earnings grow tax free)," advises Laura Seymour, a certified financial planner in Bloomington, Minnesota. "If you are self-employed, you may elect to start an Individual 401(k) for yourself – you cannot have employees."
How Much to Contribute
Everyone's financial circumstances are unique, so the amount that's best for you to contribute might be different than your neighbor. "You should consider a variety of items but review how much you"re saving in all investments, not including your emergency fund – that’s separate," advises Seymour. "It would be helpful to start with the minimum to get your employer match (if they are matching your contributions) and then enroll for an auto-increase each year of 1 percent."
Deciding Between Roth and Traditional 401(k)
If your employer offers both Roth and traditional 401(k) options, the choice depends on whether you want to pay taxes at today's rates or at your retirement rates. "If you are a higher wage earner, you may want to check with your employer on a Roth 401(k) option" says Seymour. "Remember that traditional 401(k) contributions lower your taxable income today and grow tax-deferred until you take out the money in the future. When funding a Roth 401(k), you pay the tax on the contribution today but it grows tax-free."
Once you contribute money, you must select an investment option for the money. "If this is your first 401(k), it may be prudent to select a Target Date fund based on your expected retirement date or overall asset-mix that represents your desired exposure to stocks versus bonds," says Seymour. "You will want to know how much exposure to stock funds (growth/equities) you desire (if you have thirty plus years I’d suggest 80 percent or higher) and how much exposure to bond funds (more fixed income)...It is best to learn more about each of the funds offered in your 401(k) plans by doing research on the employer’s 401(k) plan website."