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

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.

%VIRTUAL-WSSCourseInline-734%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.

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