401K

So, your job has a 401K. That’s awesome! But maybe you’re not sure where to start. That’s okay, look in the literature given to you about your 401K for the company that holds your 401K (Vanguard, Fidelity, etc). Go to their site and set it up. If you aren’t sure what to do, call them, they’ll hold your hand through it. Try to do this as soon as you learn you have a 401K so you can receive the maximum number of employer matches possible.

401K – A type of retirement account that has tax-advantages and often has an added bonus of an employer match. Mostly a replacement to a pension.

Tax-advantage – Most money that is invested is taxed before it enters an investment account and then taxed when it leaves. A tax-advantage account is only taxed once, either when the money enters (post-tax) or leaves (pre-tax). Having to pay only is a huge advantage over other investment accounts.

Note, there are contribution limits for a 401K. $24,500 if you’re under 50, and $32,500 if you’re above it. These are the total amount that you, the employee can contribute, and any that your employer contributes as a match is just extra. Try to add at least the amount required to get your employer’s match, and more. However, unlike a Roth which can have all the money dispensed into the fund at once, you want to space it out in a 401K so that you’ll get your employer match each time.

For example, let’s say that your employer is matching 2% if you put in 5%. They’re not matching 2% of 5%, they’re matching 2% of your paycheck. So, if you put in $24,500 day one, they’re still only going to put in 2% of your paycheck, and you’ll miss out on the other twenty-five 2% matches from your paycheck. Also, see if you can invest more than the match. A lot of people will suggest 15% or even 25%. don’t start there, but see if you can build up to it.

People will encourage you to max our your 401K, and I will too, but with some caveats.

• Unlike other investment accounts, 401K’s are harder to pull the money back out of once its in there. There are specific instances (buying a house, retiring, etc) which allow one to pull money out without a penalty, but all other times, any funds removed will be essentially taxed. So, don’t put your emergency fund in your 401K. Your 401K is just for retirement.
• Pre-tax or post-tax. I suggest always going with post-tax, your money will be taxed before entering the 401K but then can grow tax-free. If you do pre-tax, you might see larger gains initially, but you should know that potentially 35%, or more, will be removed for taxes when you finally retire. This means that if you have 2 million saved, you actually have just under 1.3 million. That’s a large drop. I prefer to pay may taxes up front so I won’t have to worry later on.

Side note, did you know you can also do post-tax in a Roth so you can also have it grow tax-free?

• Vested. This is an odd term, but it’s something to look out for in the literature you’re given about your 401K. If you’re not vested, it means that any employer match contributions are not truly yours until you’ve some one-time requirement, usually working a number of years (ex. 2 yrs) as an employee. Once the time limit is up, your 401K becomes vested, so you don’t have to wait another 2 years to get the next employer match. However, if you are vested from the start, it means any employer contribution is immediately yours.
• If there is an option to automatically increase your contribution each year by 1-2%, select that option (unless you’re already maxing it out) so that you can essentially forget about it.

401k’s are a powerful tool to retire, and potentially, retire early. I recommend taking advantage of them but starting at just the match and going up. I’ve reached 15% at one point and then decreased down to 6% and then increased back to 10% as my financial situations have changed. It can be a set and forget situation, but I like to keep a more active eye on mine. It’s going to be a different journey for everyone, but please remember, that although it is one of the big priorities, having a separate emergency fund can be a higher one.

Imagine you’re laid off from your job and you aren’t able to access your thousands locked up in your 401K without losing a large part of it and you never saved up anything else. That’s a tough situation but I’m glad that you at least saved up money in your 401K.

I don’t mean to discourage the 401K. It’s one of the few accounts where you get free money on top of the tax-advantages so definitely use it to it’s maximum potential, but don’t put blinders on, be aware, and use your common sense. Good luck.