3 Crucial Steps to Setting Up Your First 401(k)
Welcome (or welcome back) to the working world. In that thicket of new employee information is likely to be a booklet about the retirement savings plan offered by your employer. Chances are, your employer has set up a 401(k) account that is ready and waiting for your attention and your money. Here's how to make the most of your new account.
1. Three numbers you need to know: what you put in, what your employer puts in and how much your account grows from investment income. These three numbers, says Don Chamberlin, CEO of The Chamberlin Group, a St. Louis-based financial planning firm, are your three streams of retirement income. You can monitor these three numbers by reviewing your regular account statements.
It's easy to only focus on the top line: How much is in my account now? However, it's important to keep tabs on all three sources of income, Chamberlin says. You need to know how your own contributions add up, how your employer contribution increases your balance and how well investments are growing those combined contributions. Understanding these factors from the get-go will help you see what's really contributing to account growth so you can wisely manage your account.
First, contribute the biggest proportion of your income you can. Many people channel the amount that captures the employer match, but don't let that limit you, Chamberlin says. Try, if you can, to save a bit more than the employer match.
"The match is the biggest benefit," he says. That's the amount your employer contributes to encourage you to save. If your employer match is 50 percent, that means that your employer adds 50 cents for every dollar you save.
That's true up to a point: Employer generosity typically caps at 3 percent to 6 percent of your salary, Chamberlin says. That means if you earn $100,000 annually and contribute 6 percent of your salary, and the employer match of 50 percent tops out at 6 percent, your employer would add $3,000 to the $6,000 you put into your 401(k) annually, Chamberlin points out.
Employer contributions are "free money," Chamberlin says. "Every year you don't get the maximum match, you lose free money for your 401(k) plan," he says.
As your savings accumulate, you will start to see investment income add up, too. Sometimes, the only growth in your 401(k) will come from your savings, plus your employer match, Chamberlin says. There may be years when your employer match is lower if your employer is having trouble turning a profit. Some years, you may have a big windfall from investments. And there might be years when all three sources of income are building your account.
2. Find out what you're paying in fees. Sure, your employer picked up some of the cost of setting up the 401(k) plan for everybody. But the administrative firm that runs the plan and the investment firm that manages the money also make money by charging you fees, says Andrew Meadows, consumer and brand ambassador with The Online 401(k), a San Francisco-based company that specializes in small business and individual retirement plans.
"The 401(k) is not free, and the funds are not free," Meadows says. "It's important to know how much you're paying in fees."
It's important because a little bit of what goes into your account evaporates through fees. Fees apply regardless of how much investment income the account earns. The management fee gets paid no matter how well the investments do, Meadows points out.
When you set up your 401(k), scrutinize the paperwork to find the fees. Look for the fees in the statements that arrive regularly. Also, be aware that some financial advisers also charge a per-participant fee, usually $3 or $4 a month, for customer service, Meadows says.
3. Allocate your money to a variety of investment categories. There are two ways to think of dividing up your account into types of assets, says Anthony LoCascio, a certified financial planner and principal of the New Jersey-based firm Anthony LoCascio Consulting.
One is to plug in the year of your expected retirement and let the fund managers use established formulas to put your money into less-risky investments as you get closer to retirement. That's how a target-date fund works.
It's a cruise-control approach that is supposed to be worry-free, LoCascio says, but the problem is that the real world rarely cooperates with your retirement plan's automatic pilot. A target-date fund may work out great, but it may also be swimming against the economic tide because its assumptions aren't in sync with changing investment conditions.
Another way to get long-term results is through dollar-cost averaging, LoCascio says. He recommends adopting this approach by dividing your account among the main types of asset classes offered in the plan. If your money is evenly distributed among the main types of investments offered, you are positioned to capture consistent growth.
To adopt dollar-cost averaging, review all of the types of funds offered in the plan, LoCascio says. "Divide your assets among the main categories -- large-, medium- and small-cap stocks, and both growth and value funds in each of those size ranges, and maybe a bond fund," he says. "Divide your money evenly among them all, even if you're only putting a little bit in each one, each month."
"Dollar-cost averaging with a diverse asset allocation will give you both diversification and growth. And you won't have to rebalance your account as it grows because you started out balanced," he says.