Introduction to 401k Part 1
So you’ve just landed that new job. And you’ve heard my Savings Speech and read Chris’ article on Goal Setting and Wealth. You know how awesomely rich you could be one day and have set some goals to that effect.
I’ll sometimes be using my own 401(k) plan as an example here and try to point out some of the more common options. So if your 401(k) is a bit different or you notice something I miss, let me know.
Why 401(k)?
- Taxes: you don’t have to pay federal income taxes on contributions made to your 401(k). Taxes are only paid when you finaly begin withdrawing money, after that money has been compounding for you. The Wikipedia article on 401k is a great read that covers the tax benifits particularly well.
- Employer Match: If you have a decent employer, they will match some part of your contribution. Can you say “Free Money”? We’ll cover some examples of employer matching below.
How Much to Invest
First, use Chris’ Wealth Caculator or my own Future Wealth Calculator to find out what percentage of your salary you should be saving. (Chris’ puts more emphasis on your wealth goals, whereas mine focuses on the inputs. Let us know what features you like and don’t like of both in this topic in the forums.)
Once you’ve figured out how much you need to save, you’ll need to decide how much of that money to put in your 401(k). The most anyone can put in a 401(k) account will be $15k this year (or $20k for people over 50)[1]. Should we contribute as much as we can up to $15k? No. Or maybe I should say, not necessarily.
The biggest factor in deciding how much to invest in a 401(k) is by far your employer match. Now these can be confusing at times, so I’ll try to explain.
Your employer can match contributions up to 6% of your salary. That match is added on top your original contribution immediately and can even put you past the maximum allowed contribution. Let’s see an example: say your 23 years old, making 50k per year. You contribute 30% of your salary or $15k. Your employer can match an additional $3000 (or 6%) of your salary, pushing your total contribution to $18k. No matter how the individual investments in your 401(k) account do (more on this later), you’re already making a 20% return on your money! Nice.
Now let’s see another example. You’re still 23, still making $50k per year. This time you contribute just 6% of your salary (enough for full match), that’s $3000. Your employer will match 6% on top of that, again $3000. That’s a 100% gain on your money! The thing is, employers are expecting you to invest up to the match; they consider it part of your “package”. So you might as well take it.
Not every employer matches a full 6% of your salary (mine doesn’t either). This not only means you make less money, but it also makes the math a little harder (so stick with me). My employer matches “50% up to 6% of your salary”. What does that mean? The part after the “up to” is how much I need to contribute to get full match. “50%” is what percent of the contribution (up to 6%) they will match. What you really need to do if you read something like this is just multiply the two percentages together. 0.5 x 0.06 = 0.03 or 3%. My employer will match 3% of my salary, but I have to contribute 6% to get the full match. Here are a couple examples to illustrate.
In all examples below the employee’s salary is $50k and the match rule is “50% up to 6%”.
Your Contribution: $2500 (5%)
Employer Match: $1250 (50% of $2500 or 3% of salary)
Your Contribution: $3000 (6%)
Employer Match: $1500 (50% of $3000 or 3% of salary)
Your Contribution: $5000 (10%)
Employer Match: $1500 (50% of the first $3000 or 3% of salary)
Notice in the third example that you don’t get any more match past a 6% contribution. This doesn’t mean that you shouldn’t contribute more. You’ll still get a tax deferred investment, but you may find better investments in company stock options, IRAs, individual stocks or mutual funds your plan doesn’t allow. Bottom line: contribute at least to the match, look for other investment options, and contribute up to your maximum only if you can’t find something better (or are making so much money that $15k is 6% of your income).
What Now
Your 401(k) plan will offer you a number of options to invest your contribution in. Typical 401(k) plans include a variety of Mutual Funds, including stock funds, bond funds, and mixed (balanced) funds. Some plans also include Company Stock Options or Money Market Funds. This great introduction to 401(k) has some good advice on how to pick between the different options, including a complete list of options that may be available.
There is a lot of advice out there on this. I won’t repeat all of it here. In Part 2 of this series, I’ll walk through how I came to choose the funds I did and talk about some of the other maintenance steps you can do to keep your plan running smoothly.
41 Comments Add your ownSubscribe
1. Intro to 401k Part 2 on I&hellip | January 26th, 2006 at 9:01 am
[…] Last week, we introduced 401(k) retirement plans and focused on their main two benifits: […]
2. 401k Redux on InvestorGee&hellip | March 2nd, 2006 at 9:00 am
[…] Okay. Now we can assume that everyone has gained access to manage their 401k. Where do we go from here? Remember, according to Intro to 401k Part 1, you’ll want to contribute at least enough to get full match from your employer. To make sure you are doing this, check your contribution percentage and update it if necessary. In my system (Hewitt) the link I want is labeled “Change Contributions”. […]
3. The IRAte Investor »&hellip | March 4th, 2006 at 3:03 am
[…] Jason from InvestorGeeks has a series on 401(k)s : Part1, Part 2, and Redux […]
4. richard littlejohn | July 5th, 2006 at 4:16 pm
I have a question. I have a 401k plan through my employer. I have been with them for 18 months. I contribute 6% of my payroll check each week and they match it with 3%. To this day they have not contributed anything to it. Is there a certain time limit that they have to contribute their part? Thanks for a response.
5. Jason | July 6th, 2006 at 8:52 am
richard littlejohn,
Some companies have an “enrollment eligibility” time, which means that they won’t start contributing right away. However, 18 months seems kind of long for that. At my currently employer, the eligibility time was 6 months.
The other thing you have to think about is vesting. This can be very confusing, but basically your employer will pledge 3% but if you were to leave your job early you would only receive a certain portion of that amount according to how “vested” you were. This is used as an employee retention tool.
Typical vesting periods are from 3-6 years. There are two kinds of vesting schedules though. Some will require you to be employed for the entire time before receiving the contribution (so-called cliff vesting schedules). Others will vest you by some % every year until you hit 100%. So if you had a 6 month eligibility period, followed by 1 year of contributions that vest gradually over 3 years, you would receive 1/3 of the total pledged amount, or just 1%.
Here’s the strange part. I’m not fully vested, yet I see the contributions my employer makes in my account. I’m given two totals. One with all contributions, and then a “vested balance”. I assume your 401k management software would act similarly.
So check what your eligibility period is. See if you are only only seeing the vested amount. And if things are still iffy, I would contact the HR department.
Here are a couple of site for further reading:
https://www.oppenheimerfunds.com/investors/ret_plans/401k.jhtml
http://www.401khelpcenter.com/mpower/feature_100200.html
Good luck.
6. Chris | August 19th, 2006 at 8:16 am
Jason,
I couldn’t find anything saying that the maximum contribution is max at 6%. In fact I found at least 1 example, where the contribution was 8%. Perhaps you’ll want to update the wording in this article.
7. Francine | January 6th, 2007 at 9:48 am
Dear Jason, Thank you for your WeathCalculator. It is the best one I have found and has really made a difference in how I am I going to save so I can reach my million dollar mark in 10 years. One question, why do you have your 5 year totals in the 6th year. Can you also recommend a program as easy for me to keep track during the year of my tax deducatable items? Thanks!
8. Jason | February 2nd, 2007 at 11:07 am
Francine, I’m not sure if I understand your question about the “5 years totals in the 6th year”. I guess I was just thinking “how much will I have 5 years from now”, which would have been 2009. I wasn’t counting 2004 because it was in the past. Perhaps it would be better if the summary automatically updated based on the current year.
RE programs to keep track of tax deductable items. I’ve been using Google Spreadsheet to keep track of expenses. I just put the date of purchase, item description, and a column for what type of expense (dinner, equipment, etc). We’ll see how that goes with the accountant this year.
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