401(k) Plans 101: A Guide to Saving for Retirement

Before you go, we thought you'd like these...
Before you go close icon
Stacks of US dollar gold coins and 401k white egg
AlamyIf your employer offers a 401(k) match, do what you can to meet it. That's free money for your nest egg.
By Steve Nicastro

If you're like many recent college graduates, thinking about retirement is probably the last thing on your mind. But the truth is, it's never too early to start saving for your golden years. The sooner you begin contributing to accounts like a 401(k), the more secure and comfortable your retirement will be.

If you just graduated from college and have landed a job that offers employees a 401(k) plan, here are a few things you should know.

What exactly is a 401(k), and why do I need one?

The first thing you need to know about a 401(k) plan is that contributions are automatically deducted from your paycheck each pay period -- before you're taxed. This is a huge advantage, as it puts tax-free money toward your retirement savings and less into the government's pocket.

For example, if you earn a gross salary of $50,000 and contribute 20 percent of your salary ($10,000) pre-tax to a 401(k), you will be required to pay federal income tax on just $40,000 of earnings. And you'll have the full $10,000 set aside for retirement.

So while your take-home pay will be a little less each month, you'll actually end up paying less in taxes while also saving for retirement -- a win-win situation.

Another benefit of a 401(k) plan: Earnings, dividends or interest accrued on investments aren't taxed until you withdraw the money at retirement. So long as you keep money in the plan and don't make an early withdrawal, you won't have to pay a dime in taxes until you withdraw the money after age 59½.

This deferral allows your investments to grow tax-free every year. By comparison, if you held the same assets in a taxable brokerage account, you'd face a yearly capital gains tax on assets sold for a gain, plus a tax on any dividends or interest earned.

"The 401(k) is the most powerful wealth accumulation strategy available to the under-30 generation," says Guy Baker, a certified financial planner with Wealth Team Solutions in California. "Not only is the money that is deposited pretax, but the tax-free growth means the money can grow unabated for 40 years."

Keep in mind, though, that penalties for early withdrawals can be severe. Take out money from your 401(k) before you hit 59½, and you'll likely be taxed at ordinary income rates, plus face a 10 percent federal tax penalty.

My employer offers a 401(k) "match" -- what does this mean?

If your employer tells you it will match part or all of your 401(k) contributions, it's time to celebrate -- your company is essentially saying it will give you free money to help fund your retirement.

For instance, say your company tells you it will match half of the first 6 percent you contribute to the plan. If you earn $50,000 a year in salary and contribute 6 percent, you'd fund your 401(k) with $3,000. In addition, your employer will be kicking in an additional $1,500 at no cost to you.

"If it's a 50 percent match, then it is like getting a 50 percent guaranteed rate of return, and if 100 percent, then a guaranteed rate of 100 percent return on your investment," says Allan Moskowitz, a certified financial planner with Progressive Wealth Management in the San Francisco Bay Area.

How much should I contribute to my plan?

You are ultimately the one who decides how much of your paycheck you'd like to contribute. If you can't afford to stash away a huge amount -- whether it's due to your student loans or just paying for everyday living expenses -- consider putting in less money at first, and increase your contributions only when you feel more comfortable.

If your employer offers a 401(k) match, it's generally a good idea to contribute at least up to the amount of the match, to avoid leaving any free money on the table. After a while, you might not even miss the money being deducted from your check, since you never see it to begin with.

"If you are leery about committing to a 401(k) and worried about tying the money up, don't be," says Howard Dvorkin, an accountant and founder of Consolidated Credit Counseling Services. "The automation of a 401(k) plan trumps concerns because you'll save for the future without having to think about it, and the penalties for early withdrawals will help keep you from dipping into the money."

If you are younger than age 50, the most you can contribute to a 401(k) plan is $17,500 for 2014; for those 50 and over, the limit is $23,000. If you're worried you might exceed the limit because of the generosity of your employer, don't worry. The match doesn't count toward your contribution limit.

What should I invest in?

The next step is figuring out what you should invest in. Your employer plan may offer a range of investments, including:
  • Stocks (shares of ownership in a company).
  • Bonds (debt issued by a government or business).
  • Exchange-traded funds (a security that tracks a major index such as the S&P 500).
  • Mutual funds (professionally managed investment funds or index-tracking funds).
  • Target-date funds (funds that adjust your assets to be more conservative as you approach retirement).
The variety of your options will depend on your company's plan provider. Before choosing any investment, consider how long you want to invest for and your tolerance for risk, each fund's performance record, the track record and turnover of a fund's management team, and fees and expenses for each fund.

The younger you are, the more risk you can bear. So investments in riskier assets with higher growth potential -- like individual stocks or stock-based ETFs -- should outweigh safer investments like bonds earlier on, Dvorkin says.

"Generally speaking, if you're under 35 years old, the percent of riskier stocks should outweigh bonds by about 20 percent to 25 percent," he says.

Don't be too concerned about the stock market plummeting, either. If the market falls, use the lower stock prices as a long-term buying opportunity, Moskowitz suggests. "When the market drops, your contribution buys more shares," he says. "Think of it as if the market is on sale -- you get more with the same amount of money."

If you are still worried about making the wrong investment decisions for your 401(k) plan, consider sitting down with a financial professional for personalized guidance.

Steve Nicastro is a financial writer for NerdWallet.com, where he covers topics such as investing, credit cards, mortgages and insurance. He previously was an editor at Patch.com and contributor to Seeking Alpha and GoBankingRates.com.

7 Best Places to Retire Worldwide If You're OK Going Full Expat
See Gallery
401(k) Plans 101: A Guide to Saving for Retirement

Medellin has a notorious reputation among Americans who know it mostly for its drug-laden past, but that hasn't prevented a huge expat population from springing up within city limits. Medellin is an incredibly walkable city, and its El Poblado district has Japanese, French, seafood and Italian restaurants within a block of each other.

Its health care system ranks near the top this list, while the cost of everything from housing to entertainment are a great fit for a fixed income. The average rental on a one-bedroom apartment in the center of the city is $650, while the average cost of buying a place is $1,050 per square meter. A taxi will get you anywhere in town for $2.50, while buses and trains can be found for much less. Plus, with the average high temperature topping out at 73 degrees, the average low coming in at 54 and a couple of rainy seasons in spring and fall, it's cool and comfortable.

Four seasons, lots of English speakers, all the Western amenities, entertainment and dining options that couples honeymoon here for ... that socialist universal health care that folks back home kept wailing about. Is there anything Pau doesn't have going for it?

Well, just consider the fact that you still have to pay for it all. The average cost of living here comes in at little more than $1,900 a month. That's not terrible by western standards, but it's more than the $1,530 you'd pay in Medellin. A whole lot of that cost comes from the nearly $1,300-a-month average cost of an apartment, which is roughly double what you'd pay in Colombia. Pau is still one of the most affordable places to live in France and is one of only two European locations on our list. That said, on a global scale it isn't exactly cheap.

It's a bit rainy and the average high temperature is in the 90s, but you're on an island in the Pacific living in one of the cheapest cities an expat can ask for.

Located along a sheltered coast on the island of Negros, Dumaguete avoids many of the typhoons, floods, landslides and tsunamis that plague other areas of the Philippines. The cost of living there comes out to roughly $920 a month, making it one of the cheapest places to live on this list. The real estate values help out quite a bit, as even prime downtown apartments can be had for $350 a month, while real estate goes for roughly $1,200 per square meter.

For that, you live in a beachfront, tropical climate with excellent health care, lots of activities and one of the best residency programs in the world. If you're there, have roughly $800 a month in income and are over 50 years old, you can live there with no required residency period and with a bunch of discounts as a result of residency.

The good news is that you can live really well here on $920 a month. The bad news? You're doing it in a city where the average high temperature is 99 degrees year-round and the average humidity sits at 85 percent.

Oh, and the nearby farmers burn their fields at the end of harvest season, making the air in town practically unbreathable.

That said, hillside Chiang Mai offers a lot for the money. An apartment downtown goes for a ridiculously low $400 a month, while homes can be bought for $1,100 per square meter. The high-quality health care and health-related services are huge bonuses, as are Western amenities and jobs for foreign residents. Many Westerners are employed in Chiang Mai in language schools, universities, medical facilities and tourist-related industries.

The country's Malaysia My Second Home retirement benefits program for all foreigners is a great draw, but so is the quality Internet access, cellphone coverage and roads.

If you can prove $3,125 in monthly income and make an investment in a local CD, you're going to be living on the cheap for the foreseeable future. The average monthly cost of living comes out to $1,070, with apartments renting for just $500 and homes selling for $1,700 a square meter.

George Town's population of 740,000 isn't exactly tiny, but it's small enough so that it's easy to make friends and meet people in a city where English is spoken just about everywhere. The health care is outstanding, the infrastructure is just about Western and the population of expats is around 40,000 -- a city unto itself.

Ecuador is Florida or Arizona for the expat community.

The country's retirement benefits package includes 50% off transportation, utility bills, international round-trip flights originating in Ecuador and tickets for cultural and sporting events. Foreigners can also enroll in the Ecuador Social Security medical program for $57 a month. Those over 65 also pay lower income tax. Oh, and there's no required minimum stay for residency.

At $1,010 in average monthly costs, Cuenca is also insanely cheap. Apartments downtown rent for $300 a month, with homes selling for $1,100 a square foot. Your neighbor is also likely to have a few stories to swap, as there are roughly 4,000 to 5,000 North American expats living in this small city. There are lots of restaurants and nightlife and just enough English spoken to ease the transition.

This Old World region on the Atlantic Ocean, home to more than 100,000 resident expat retirees, medieval towns, fishing villages, open-air markets, local wine and some of Europe's best sandy beaches. Dotted with cobblestoned streets and whitewashed houses with lace-patterned chimneys, surrounded everywhere by fig, olive, almond, and carob trees, it's a European dream location.

It has four seasons, including one of Europe's most sought-after summers, nearly no crime, strong infrastructure and universal, international-standard health care. That said, it isn't exactly overrun with English speakers, so you may want to brush up on some Portuguese before hunting for homes here. Still, with 42 golf courses in less than 100 miles and a cost of living that averages out to between $1,500 and $2,000 a month -- including rent at around $615 a month -- there's a whole lot of motivation to learn the language and stick around a while.

Read Full Story

People are Reading