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.

For most people, the 401(k) savings plan offered by their employer is the first investment worth making. This article is meant to introduce you to the 401(k), why it’s often a good deal, and how to get started.

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)?

  1. 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.
  2. 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.