You probably already know that a 401(k) has something to do with saving for retirement. If that's where your knowledge of 401(k)s begins and ends, you've come to the right place.
A 401(k) is a special tax-advantaged retirement savings account that your employer makes available to you. If your company has a 401(k) plan, you can choose to direct some of your wages into your 401(k) account instead of to your paycheck. In your 401(k), your money will be invested in assets that will (hopefully) grow in value over time, eventually leaving you with enough money to retire on. One of the major benefits of a traditional 401(k) is that your contributions come out of your pre-tax salary, so contributing money will actually reduce your tax bill.
Continue Reading Below
A tax savings example
Let's say you're single and your salary is $50,000 per year. If you didn't make any 401(k) contributions, then for 2017, your federal taxes would come to $8,238.75. Now let's say you instead contributed 10% of your salary to your 401(k) account. That $5,000 contribution would reduce your taxable income to $45,000, meaning that for 2017, your federal taxes would be just $6,988.75. In other words, you'd save $1,250 on your annual tax bill by contributing $5,000 to your 401(k).
How to sign up for a 401(k)
In order to open a 401(k) account, you have to have an employer who offers a 401(k) plan. Just speak with your HR representative to find out what you need to do to set up your account. It usually only involves filling out a couple of forms. If you're self-employed, you'll have to provide your own retirement plan -- such as a solo 401(k) or a SEP IRA -- and if you're an independent contractor, you're out of luck on the 401(k) front. That said, nearly anyone can open an IRA, a retirement savings account that offers similar tax breaks.
How to make contributions
Once your 401(k) account is open, you can start making contributions from your paycheck. 401(k) contributions are typically a fixed percentage of your salary; you can contribute anywhere from 1% to 100% of your paycheck, with the important caveat that the IRS puts an annual contribution limit on 401(k)s. For 2017, you can contribute up to $18,000 -- plus an extra $6,000 in "catch-up" contributions if you're age 50 or older.
The great thing about contributing a set percentage of your wages is that as your salary grows, so will your 401(k) contributions. This, along with compound interest, will rapidly accelerate your retirement savings. To ensure a well-funded retirement, aim for at least a 10% to 15% contribution level; if that seems too high, start at a lower level and gradually increase it until you're at the desired savings amount.
If your employer will make matching contributions on your behalf, then that's the biggest benefit of all. Typically, employers will match every dollar you contribute up to a certain percentage of your salary. That's like getting an instant 100% return on your investment, so make sure you contribute enough to your 401(k) to receive the full match. If you don't, you're passing up free money.
What to do with your contributions
Once you contribute money to your 401(k), the next step is to decide how to invest that money. The simplest choice is to put the money in a target date fund that automatically allocates your money in different investments depending your planned retirement date. For example, if you plan to retire in the year 2060, you'd want to put the money in a 2060 target date fund (most target funds have the planned year of retirement in the name of the fund). As the years go by, the fund will slowly shift your money into safer, less volatile investments in order to preserve the capital you've built up.
Another option is to put part of your retirement savings in a stock mutual fund and the remainder in a bond fund. Spreading your money out over these two different types of investments helps to mitigate your risk. However, though bonds are relatively safe investments, they're also slow-growing, so they will lower your overall return. To lower your risk without sacrificing too much growth, you should keep the majority of your savings in stocks. One decent guideline is to subtract your age from 110 and put that percentage of your investments into stocks, with the remainder in bonds. For example, if you're 25, you'd put 85% of your money in stocks and the other 15% into bonds. Whenever possible, stick with index funds and index ETFs, as they have much lower fees and expenses.
How to find out more about your 401(k)
401(k) plans differ in their fees, investment options, and other features. The best resource for learning more about how your own plan works is the summary plan description. Employers are required by law to give you an SPD when you enroll in your 401(k) and whenever there are changes to the plan. Take the time to at least skim this useful document to get a better understanding of your plan and how it works. If you have any questions, be sure to ask your HR representative or get in touch with the 401(k) plan trustee's customer service department. The more you know about your 401(k) plan, the more likely you are to maximize your returns and minimize fees.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.