The Ins and Outs of Retirement Accounts, Part 1: The 411 on 401(k)s

401 (k)
401 (k)

Like sunspots and wrinkles, saving for retirement is one of those things that can be hard to take seriously when you're young. Still, in the same way skin damage accumulates over time, so do retirement savings. The more sunscreen you wear now, the better you'll look in your 60s, and the more money you stash away today, the better your financial health will be then too.

Because investments can generate compound returns -- that is, you can make profits on your profits, not just your principal -- starting early makes a big difference. Consider this example, which I did with a simple retirement calculator:

Let's say you're 25 years old, you get paid twice a month, and you've decided that you are going to have $100 from each paycheck deposited directly into a retirement account. Let's assume your investments earn 6% a year. Let's also assume that you never get a raise, never take a pay cut, and instead just continue adding to it at the same rate until you retire at age 67. At that point you'll have $422,281 in your account.

Now, let's keep everything the same, but assume you waited until you were 35 to open the account. In that scenario, when you retire at 67, you'll have just $218,125. Even though you only deposited a total of $24,000 into the account during those first 10 years, that money is worth a whopping $204,000 by the time you retire. Which is why, if you haven't done so already, you should immediately start a retirement account.

If you're still not convinced, ask yourself who will fund your retirement, if not you?

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"So much has changed over the past 20 to 30 years," explains Catherine Golladay, vice president of 401(k) education and advice at Charles Schwab (SCHW). "We're really going from an environment where between a pension plan you might have from your employer, and Social Security, many people were really well prepared for retirement. Today, with the doubts people have around where Social Security may be in 20 or 30 years, and the fact that most employers have transitioned away from a pension plan where they're taking the responsibility to a 401(k) plan, that's really changed the game. So individuals need to take more responsibility for retirement."

In this three-part series, I look at just how to do that. In this first installment, I'll review how best to manage a 401(k), the standard retirement plan offered by private employers. In part two, I'll provide advice from financial experts on what to do with your 401(k) if you've lost your job. In part three, I'll consider various retirement options for people who are self-employed, unemployed or otherwise do not have access to an employer-sponsored retirement account.

401 (k)
401 (k)

Part One: Making Your 401(k) Work for You

For those of you with access to a 401(k) -- or a similar benefit like a 403(b) -- the first question is: Are you using it? "Depending on the plan, between 10% and 30% of employees don't participate, and typically it's the younger people," says David Wray, president of the nonprofit group Profit-Sharing/401(k) Council of America. "Younger people are really strapped. They don't manage their money well, they get in trouble and then it's hard to save. They are at the lowest income level, and there is a lot of pressure to spend."

If you're one of those who has declined to used your 401(k) because you don't know how they work, this 401(k) primer is an easy way to learn. Otherwise, here's advice from the pros on how best to manage it.

1. Enroll as Soon as Possible: "Retirement in your early 20s can seem a long way off," admits Joseph Montanaro, a certified financial planner at USAA. "But that's the biggest advantage you have -- it is a long way off, meaning you have time on your side. If you can think about it now, and leverage your time, that's a real advantage."

2. Consider When it Makes the Most Sense to Pay Taxes: There are two flavors of 401(k)s -- the traditional, deferred version and the Roth. They differ only on the question of when you pay the taxes on your savings. With a deferred 401(k), income is deposited into the account, and you pay taxes on it only when you withdraw it. In a Roth 401(k), you pay taxes on the money before you deposit it, and don't pay any taxes when you withdraw it.

"The best practice is to save in a Roth when you're young and your income is low, and switch to deferred savings when you're older and your income is higher," explains Wray. At the start of your career, when you're earning less money, you'll be in a lower tax bracket. As you progress and begin earning more, you'll eventually jump up into a higher bracket. Since you'll have to pay taxes on the money eventually, better to pay them now, while your rate is lower. Wray suggests switching from the Roth to deferred once you begin earning $40,000 a year, which is roughly the point at which your tax rate at the time of retirement will likely be less than your tax rate while working.

3. Contribute Enough to Qualify for the Full Match From Your Employer:Remember, your employer will match your contributions up to a certain point. "That's free money," says Montanaro, "and you don't want to leave any of it on the table."

4. Make it a Habit: Like any other savings account, there are two components to managing your retirement funds. First, you have to commit to consistently saving the money. That's where a 401(k) is so helpful -- your employer can deduct your contribution directly from your paycheck so that the money immediately goes into your retirement account. These automatic deductions make it much easier to stay on track, both because you don't have to remember to move the funds, and because you won't be so tempted to blow the money for that weekend ski trip your friends are planning.

5. Don't Be Afraid to Ask for Help: The second component to successfully managing your retirement account is to be thoughtful in how you invest. "If you're going to do a good job of investing your 401(k), you have to have the time, the discipline and the knowledge to understand your investment choices and how you should allocate your funds between those choices," explains Golladay. "And that's hard to do -- to have all three of those components -- so that's one of the reasons why if you've got independent 401(k) advice [provided through your company], you should take advantage of that."

If your company doesn't provide access to these sorts of services, Golladay says you can consider a "target-date fund," a type of mutual fund that mixes stocks, bonds and other investments, and routinely resets its risk profile, depending on when you want to retire. "As you get closer to retirement, the fund moves on a glide path from a more aggressive portfolio -- more stocks -- to more conservative -- more bonds and cash .... So a target date [fund] is a good starting place" when more personalized advice is unavailable.

6. Don't Put All Your Eggs in One Basket: Just because your company offers stock -- or matches in it -- that doesn't mean you need to -- or should -- load up on it. "I wouldn't stay in more than 15% to 20% in [your] company stock," advises Golladay. "It's not necessarily because it's your own company's stock. It's because if we see anybody with any stock or bond at more than 15% to 20% of your portfolio, we would consider that heavy concentration in one area."

Next up, in part 2, I look at how best to manage your 401(k) after a layoff. Then, in part 3, I review how to create your own retirement account if you are unemployed, self-employed, or otherwise don't have access to one through an employer.

Loren Berlin is a columnist at She can be reached at You can follow her on Twitter @LorenBerlin, and become a fan on Facebook.

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