Congratulations! You made it through several rounds of interviews and landed a sweet new job. Your first day is full of the usual jitters: planning the right outfit, showing up on time, and avoiding getting lost. You have been walked around the office and introduced to people whose names you can’t remember. You have filled out your name, address, and social security info on your W-4, I-9, and insurance forms, all before seeing your new cubicle. Finally you’re presented with a glossy pamphlet detailing your financial future — your 401(k) plan paperwork. Ugh.
Look, I’ll admit it — I’ve worked in finance for years, and sometimes even my eyes glaze over when it’s time to make personal financial decisions, but understanding how your 401(k) plan works is important both for short-term tax savings and long-term financial stability. Here are five tips to making the most of your plan and tackling the mounds of paperwork.
Unfortunately, employer matching has become less of a given since since the Great Recession. However, if your employer offers this benefit, it is one of the most compelling reasons to participate in the plan. If your employer does matching, they will make a dollar-for-dollar deposit to your account based on what you give, or will sometimes have a phaseout. For example, a 100 percent match for the first three percent of your salary you contribute to the plan, followed by a 50 percent match for the next three percent. This is perhaps the only “guaranteed” investment return you will ever see. Not participating in the plan means leaving free money on the table.
This is similar to an employer match, but better and more rare. An employer contribution is the amount an employer contributes to your 401(k) regardless of what and whether or not you contribute. In pre-recession days, my previous employer contributed 8.5 percent of an employee’s salary to 401(k) plans. However, contribution should not be looked at as an incentive not to add your own savings. Your company is making an investment in your future, and you should certainly make a similar investment in yourself!
Even if your company doesn’t offer a match or contribution, you should still contribute to your 401(k). Why? Tax savings! Your 401(k) contribution is made pre-tax, which means your taxable income is reduced. To break this down further: Assume you make $50,000 a year and contribute 10 percent of your salary to your 401(k). You are now taxed on $45,000 per year instead of $50,000 per year. And while the $5,000 you put away isn’t in your pocket now, it is being invested in your future. As for how much you contribute, you should definitely contribute as much as you can to max out your employers’ benefits. After that, see if you can target your total contribution to 10 percent of total income when you are starting out. The maximum amount you can contribute to your plan is $16,500 a year. If you’re able to do that, fantastic! But if not (and I think a lot of us are in this boat when starting out), try to contribute 10 percent annually.
This is the part that gets tricky and causes a lot of people to freeze up. You’ve signed up for your plan, but now how do you invest the money? In my first job, I “invested” in money markets because I was too scared to research the stock market. This investment yielded a conservative one percent return while the S&P 500 was averaging 8.75 percent annually. Is there anything wrong with being fiscally conservative? Absolutely not! But there is something wrong with being uninformed. Had I spent a few minutes talking to a trusted advisor or my plan’s administrator, I may have made the same investment decision, but it would have been an informed one. Your 401(k) plan likely comes with an option of 20 or so mutual funds to choose from. The easiest option is to choose a targeted date fund which chooses investments based on your likely retirement date. These funds will have names like XYZ Target 2040. It is worth noting that these funds may have higher fees than other funds, but you are paying for ease and peace of mind.
Another option is to construct your own portfolio, which is something I’ll delve more into in future posts, but the idea is that your conservative investments (money markets, bonds) should be in a percentage roughly equal to your age, and your riskier investments (stocks, international funds) would be the rest. Of course, there’s more to this, and I recommend talking to either your HR rep or plan administrator to get help. It can be intimidating when you’re unfamiliar with financial language, but plan administrators are paid (handsomely) by your company to be a resource to you. It is their duty to help you, so don’t feel shy about calling for advice.
The investments in your 401(k) are there for the long haul. I wouldn’t say to ignore your plan completely, but you also shouldn’t freak out about daily (or minute) swings in the market for your plan. Review your quarterly performance to see how your funds have done against benchmarks (similar funds) and adjust annually as needed.
What is the best long-term investment you’ve made and how did you keep yourself incentivized to do so? Tell us in the comments!
Ask Levo Mentor Warren Buffett, CEO of Berkshire Hathaway Inc., his best investment practices at any point in your career!