3 Things You Should Know Before You Sign Up For a 401(k)
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If you start a new job, you might have the option of enrolling in your employer's 401(k) plan. Many people simply choose the "default" options, which include a certain group of investment funds and the contribution amount that takes full advantage of the employer's matching program. However, there is more to a 401(k) than meets the eye. Here are three things our experts want you to know before you sign up for your next 401(k).
Matt Frankel: One important thing to know is how much you should contribute to provide the financial security you want in retirement.
Too many people simply contribute however much money their employer is willing to match. For example, if the employer matches 401(k) contributions of up to 3% of an employee's salary, that's exactly what they contribute.
However, this should be viewed as a bare minimum. Contributing even a little more can make a big difference in your long-term financial health. Consider an example of a 30-year-old worker who earns $50,000 per year and plans to retire at 65. If the employer matches 3% of that person's salary, check out the big difference additional contributions can make in his or her final retirement nest egg.
Note: Assumes 2% annual salary increases and 7% annual average investment returns.
The IRS allows elective 401(k) contributions of $18,000 for the 2015 tax year ($24,000 if over 50), but the chart shows you don't need to max it out to make a big difference.
One good strategy is to increase your contributions by 1% of your salary each year until you reach your desired contribution level. Or, whenever you get a raise, use half of it to increase your retirement contributions. You probably won't even notice the small amount of extra money coming out of each paycheck, and it could be well worth it over the long run.
Selena Maranjian: Before you start diverting dollars from your paycheck into a 401(k), know that there is a good chance that two different kinds of 401(k)s are available: traditional and Roth.
The two types are very much like the traditional IRA and Roth IRA. With the traditional forms of both, you contribute pre-tax money that reduces your taxable income and, therefore, your tax bill for the year. When you withdraw the money in retirement, it's taxed as ordinary income. With the Roth forms, you contribute post-tax money -- i.e., sums that don't offer any up-front tax break. But in retirement you get to withdraw all the money out of the account tax free.
That's a big deal, in part because 401(k)s have significantly higher contribution limits than do IRAs and therefore let you build big nest eggs faster. For 2015, the contribution limit is $18,000, plus a $6,000 "catch-up" sum for those aged 50 and up. (IRAs only permit up to $5,500 in 2015, plus a $1,000 catch-up allowance.)
Both forms of the 401(k) have their advantages. If you're in a very high tax bracket now and expect to be in a low one in retirement, it can be well worth it to defer taxation on a chunk of your income. But if you expect to build a big retirement nest egg over many years with a 401(k), the prospect of keeping it all, without taxation, is rather appealing.
If you love your Roth IRA and wish you could contribute more to it each year, consider the 401(k) -- if your employer offers one. According to Aon Hewitt data, only about 11% of employers offered the option in 2007, while fully 50% did in 2013, up from 40% just two years earlier. An employer that doesn't provide one today might offer it tomorrow.
Jason Hall: The 401(k) is probably your best way to save a lot of money for retirement, when you factor in the benefits of your employer's matching contributions, the tax benefits, and the amount you can set aside each year. However, it's not a "free" way to invest, and there are fees that can have a much bigger impact on your returns than you realize.
Most 401(k)'s offer a pre-selected list of mutual funds in categories based on risk or type of investment. Chances are you're paying 100% of the fees associated with managing these funds, even though you'll never see a bill since the fund simply deducts its expenses from the assets it manages for you. The fund is required, of course, to disclose how much it charges, and this information is easily accessible in the fund's prospectus.
Why does it matter? Because you should consider the fees when you choose your investments. Mutual funds that are actively managed, meaning there are people picking the stocks, typically charge higher fees; however, as a group they don't give better returns than cheaper, passive funds that track a major index such as the S&P 500.
In short, if your 401(k) offers both active funds and passive index funds, the passive funds are more likely to charge lower fees and give better returns over time. Combined and compounded over many years, even an additional 1% or 2% in better performance and lower fees can be worth tens of thousands of dollars in returns when you retire.
The article 3 Things You Should Know Before You Sign Up For a 401(k) originally appeared on Fool.com.
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