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How to set up your 401(k)

How to set up your 401(k)
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A 401(k) is a retirement plan offered through your employer. The plan allows for workers to put money aside for retirement on a special tax-advantaged basis, helping them save for their golden years more quickly.

Most 401(k) plans are offered for the first time to employees when they begin a new job or after a certain holding period, such as 30 days after a worker’s first day. The process of how to enroll in a 401(k) depends on the company: some firms automatically enroll their employees and others do not.

Here are a few ways to set your 401(k) investments up, whether it’s the first time or they’ve been on autopilot for a while.

1.Make sure you’re enrolled

Some employers will automatically enroll an employee into their 401(k) at a predetermined percentage of their salary. Other companies will leave the onus on new employees to enroll themselves either after an initial waiting period, or in some cases immediately after starting to work.

The good news is that you can enroll in a 401(k) year-round, and contributions are flexible. This means you can increase, lower, or pause your contributions to the account any time you wish.

Use your company’s benefits platform or contact your Human Resources representative, to find out who your 401(k) provider is. From there, you can find out if you have already been enrolled, or you can enroll yourself if you’re not.

2. Set a contribution amount you’re comfortable with

The annual 401(k) contribution limit for 2022 is $20,500, so the percentage of your salary that is needed to reach the limit depends on how much you make.

If you cannot contribute the maximum, think about starting small. The most important thing to do is to keep constantly investing each paycheck, regardless of the amount. You can always increase your contributions as you go along.

3. Choose your investments wisely

There are typically two different investment paths you can choose in a 401(k): self-directed investing or managed advisory. Although your employer sponsors the plan, you maintain all responsibility for the account’s investments.

Self-directed investing: This is where retirement savers choose from the plan’s available funds and set up how the 401(k) is allocated.

The number of investments available will depend on the company and the plan carrier. According to FINRA, the average 401(k) plan will offer eight to 12 investment options. Sometimes, these options can be all mutual funds. Mutual funds are the most common type of investment offered by 401(k) plans.

Alternatively, a mix of mutual funds, individual stocks and bonds, guaranteed investment contracts, company stock and variable annuities may be available. Company stock is sometimes offered if the company is publicly traded. Variable annuities are also sometimes offered, which combine an insurance contract with a brokerage account component.

These are just examples, as the exact mix of securities offered will depend on the employer.

For each potential investment, investors can access prospectuses that detail relevant information about each fund. Investors will have access to fund performance and costs, which are crucial in determining if an investment is right for you.

Another option is target-date funds. These funds are automatically calibrated for risk depending on the anticipated date of retirement for each investor. Target-date funds are typically invested in a mix of stocks, bonds, Treasurys and international equities, depending on the amount of risk that is appropriate for one’s age.

For example, a 30-year-old investor who presumably has 30-plus years before reaching retirement age will likely be in a target-date fund that holds more equities and riskier securities than a 58-year-old who is nearing retirement. An older investor’s target-date fund gradually starts moving investments into bonds, cash and safer investments to prepare the investor for retirement.

Target-date funds are a kind of set-it-and-forget-it way to make sure you’re putting money away for retirement without actively keeping an eye on it.

Managed investments: For investors who want someone to manage their money, they can choose to have financial advisors actively invest their 401(k). The provider will usually establish risk tolerance for the investor and then pick investments suitable for their risk profiles.

For example, if an investor agrees to be put in high-risk investments, they might be exposed to more stocks and volatile investments than someone in a target-fund of the same age.

4. Take into consideration the fees

Most 401(k) plans offer a range of mutual funds that investors can choose from. Mutual funds usually charge investment fees that can eat into returns, so this will need to be taken into consideration when choosing the right funds for you. These fees are detailed in the fund’s prospectus.

If you go the managed investment route, you will be paying a higher investment fee than someone in a target-date fund or who chooses their own mix of funds for the account, as you’ll be paying for the advisory services in addition. Each plan has its own service fees which need to be evaluated before making the decision.

5. Choose between traditional and Roth options

401(k)s can either be invested in a traditional account or a Roth account.

Traditional 401(k)s take money out of your paycheck on a pre-tax basis. It grows tax-deferred, and is taxed on the back-end when you begin taking distributions during retirement.

With a Roth 401(k), money is invested post-tax, meaning you won’t get a tax break on your contribution. However, the contribution grows tax-free and any money can be withdrawn tax-free during retirement.

Each type comes with advantages and disadvantages. In a traditional 401(k), your contributions lower your taxable income today, but you are deferring your tax responsibility to some time in the future and will pay an unknown tax rate. With a Roth, you have the advantage of tax-free qualified withdrawals, but will not enjoy upfront tax savings.

You are allowed to keep money in both a traditional and Roth 401(k), as long as you do not exceed the $20,500 annual limit on contributions across all accounts. This can be a good way to create tax diversification if you want to take advantage of what both accounts can offer.

6. Maximize your employer’s 401(k) match

Some employers will match their employee’s contributions at either 50 or 100 percent up to a certain amount, sometimes 3 to 5 percent of an employee’s salary. That’s free money that you should take advantage of, if you can.

Some plans will also require a vesting period before employees are entitled to fully own company matches, often for a year or longer. Vesting schedules vary by company, but they mean that if you leave your job before a certain time period, you will not be able to keep the money your employer contributed on your behalf. Your own contributions, though, are always fully vested and available to you.

After fully meeting your company’s vesting schedule, you will have 100 percent ownership of any matching contributions.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

Written by
Georgina Tzanetos
Investing reporter
Bankrate reporter Georgina Tzanetos covers investing and retirement.
Edited by
Senior wealth editor