The 401(k): an introduction

The term is thrown around all the time, but what really is a 401(k) plan? Trent Hamm explains.

Debbie writes in:

I’m a 28 year old single mom. I just got a great job as an administrative assistant, one that I was extremely lucky to get. During orientation we were asked to sign up for the 401(k) plan. I don’t know anything at all about 401(k) plans, but I have enjoyed your site for a long time and I love the way you make money issues seem easy. Could you explain what I need to know about 401(k) plans in the simplest terms possible?

I’ll do my best.

What is a 401(k) plan? A 401(k) plan is just a very simple way for people to save for their retirement. Almost all of the time, a 401(k) plan is offered by a company to their employees, which is why you were encouraged to sign up for it during your employee orientation.

After you sign up, you’ll agree to put aside some percentage of your paycheck for this plan. Think of it as being a special kind of savings account, and the money you set aside goes into that account.

So, let’s say you’re going to make $26,000 a year, and you get paid every two weeks. That means your grosspay – the amount you’re going to make before taxes are taken out – would be $1,000 per paycheck.

The percentage that you agree to take out of your check comes out of that gross amount. So, if you’re going to put 5% into your 401(k), $50 from each check will be put into your 401(k) account.

Then, your taxes will be figured based on $950 per paycheck, not $1,000 per paycheck. That means you’ll actually be paying less income tax than you would if you were contributing nothing to your 401(k). You’ll be contributing $50 per month, but your paycheck would actually go down by less than $50.

You do end up paying taxes on the money, but you don’t do it until money comes out of the 401(k), usually at retirement age.

How much should you be contributing? I would suggest a minimum of 10%, regardless of age. If you’re over 35, make it 15%. If you’re over 50, make it 20%.

What about employer matching? Some employers offer matching contributions to their employee’s 401(k) accounts. Essentially, these contributions act as free money in your 401(k).

Let’s say your employer matches half of your contributions up to 10%. In the above example, you’d be contributing $50 per paycheck to your 401(k) and your employer will put in $25 on top of that. This makes your 401(k) contributions even more valuable.

What about all the investment options? When you put money into your 401(k) account, that money will need to be channeled into one of the investment options offered by your employer’s 401(k) program. The options vary greatly from company to company, too, which can add to the challenge.

Let’s make this clear right off the bat: don’t worry about picking the “best” investment. Making contributions and putting them in any investment option is going to be better than not making any contributions at all.

If you’re not sure which one to pick, there are a few simple guidelines I suggest.

First, choose a “target retirement” plan if they’re available. You’ll be able to choose among several target retirement plans. These plans are usually distinguished by different years – Target Retirement 2045 and so on – so choose the one that comes closest to the year that you’ll turn 67.

If that’s not available, subtract your age from 70, then double that number. So, in Debbie’s case, she’d take 70 minus 28, which is 42, and then she’d double it, to get 84. Contribute that percentage to stocks. If there are different stock options available, ask the person in charge of your plan for the option with the most diversification. Then, contribute the rest to bonds – again, if there are different bond options, ask for the one with the most diversification. You’ll want to readjust your plan every year or two, because the closer you get to retirement, the more you’re going to want in bonds and the less you’re going to want in stocks.

This should cover the basics. A 401(k) plan is simply a way to make sure you have money set aside for you in retirement. In some places, your employer will contribute extra. If you’re not sure which investment option to take, choose a target retirement fund – and if that’s not available, follow a really simple formula. Do those things and you’ll be set up for retirement.