Do Your Homework: Understanding How 401k Plans Work

When I first started working, my employer offered a 401(k) retirement plan. I didn’t know too much about it other than I could save for retirement, just as the name implied. So, I signed up. Although many workers have access to some type of retirement savings plan through their employer, like me when I started, few truly understand the inner workings of these plans or have much justification for why they chose the underlying investments that they did.

And I completely understand why!

On the surface, 401(k) plans just sound so simple. Money is taken out of your paycheck and invested based on your preferences. If you’re lucky, your employer might even contribute a little extra on top. So far it sounds like you could just set it and forget it, right?

Well, not quite.

Each employers’ plan is different which means that there is never a one-size-fits-all method of navigating the planning process. Couple that with the fact that few employers actually provide any real guidance on the how to distinguish between the different investment options and it’s easy to see why so many Americans are confused when it comes to preparing for retirement.

If you’re part of the crowd that can relate to being a little overwhelmed when it comes to what you should focus on when choosing between your retirement plan options, you’ve come to the right place.

Here are a few key aspects of retirement plans that should help eliminate the confusion and guide you toward making smarter decisions for building your nest egg.

Contributing to Your Plan

A lot is made about the investments within a 401(k) plan, which, of course, is a valid concern. But before you get to the point of picking the investments offered by your plan, you must first figure out how much of your paycheck will go into your 401(k) account.

While the amount you contribute will be based on what works given your income and expenses, the benefit of simply getting started will prove invaluable for your long-term growth.

Here’s some Mom advice: The biggest determiner of being able to retire comfortably is not the funds you pick or the market returns. It’s regular, consistent savings. In other words, if you don’t put anything in, you can’t expect to get anything out.

In fact, with pre-tax contributions, the money you sock away today will go toward reducing your taxable income — which may lead to a lower overall tax bill now.

Although the tax breaks are a great benefit, for many people the big draw to 401(k) plans is the employer contribution. If your employer offers this benefit, you’ll want to read the fine print to make sure that you’re in a position to take advantage of it.

Here are a few things to look for.

Some companies will match your contribution dollar for dollar while others will give you a percentage of your contributions (ex: $.50 for every dollar that you contribute) up to certain amounts.

No matter the matching amount, it’s (essentially) free money, and could be an immediate 50 to 100 percent return on your contributions.

Now, it’s probable that these employer matches will come with stipulations. For example, you may need to be at the company for a certain period of time before that money is vested, or yours to keep.

Sometimes the vesting schedule is gradual, meaning a certain percentage of the employer’s contribution becomes yours after a set time (say, 25% after one year on the job, 50% after two years, etc.). In other cases, the total amount becomes yours at a set period of time (say, five years of employment with the company) and if you leave prior to that time period any money contributed by the company would be forfeited.

*One thing to note, even if you leave a job before the company match vests, the money that you’ve contributed is always yours to keep — regardless of how long you worked there.

Choosing Your Investments

Choosing how to invest your nest egg includes so many different variables that attempting to help you reach that conclusion here in a blog post would be nearly impossible — not to mention a BIG compliance nightmare. That said, since you’re here, the least I could do is make sense of the overall concept of investing for retirement and hopefully give you a few things to consider for your own situation.

At a very basic level, there are two primary types of investors. Some that are more risk averse and choose investments that leave very little room for volatility, but also limit the growth potential. And conversely, others that can stomach the ups and downs of the market with the rationale that with high risk comes (potentially) high reward in the form of portfolio growth.

The thing is, 401(k) plan offerings run the gamut — from some that only have a few options to others that have literally hundreds. With such a wide range of choices available, conventional wisdom says that you should make your investing decisions based on your age and your risk tolerance.

Over the years I’ve seen a lot of advice that centers around the idea that the younger you are, the riskier you can afford to be. The thought is, if you can handle the market swings, you’re generally better off in stocks (which historically have returned more than bonds over time) for the long term.

While there is some validity to those sentiments, I would caution you to avoid choosing your investments without looking ‘under the hood’ to determine the underlying investments within that portfolio.

Far too often people choose an investment option based solely on the name of the fund, only to realize that name means nothing.

Don’t be that person!

If you’re still stuck and need to make a decision soon, a target date fund might be a good starting point. These funds help spread out your risk and automatically shift assets to more conservative investments as retirement nears.

Watch out for fees! They’re everywhere!

In addition to understanding contribution and investment options, you should also be aware of the different fees that your 401(k) plan may incur. Think about it this way: just as your money compounds over time, so do your fees. In some cases, those fees can total upwards of 30% of your portfolio by the time you retire.

The bulk of the fees you will pay on your 401(k) plan will come in the form of asset-based fees.

These are things like:

An Investment Management Fee: charged to pay for the investment manager. Typically, this fee ranges from 0.25% to 1.0% of assets in the fund.

The Administrative Expense: A fee allocated to overhead expenses, such as the cost of registering the mutual fund, mailings, maintaining a customer service line, etc. These costs can vary in size from fund to fund but typically range from 0.05% to 0.40% of invested assets.

Commissions: These fees are paid to a broker for servicing the retirement plan account. Typically this fee ranges from 0.25% to 1.0% of invested assets.

Another ‘fee’ that you could unknowingly find yourself the victim of, is one of the more common mistakes that individuals make when leaving a job — withdrawing their 401(k) balance instead of rolling it over into another account.

This is a HUGE!

If you’re invested in a traditional 401(k) plan, not only will you have raided your savings earmarked for retirement, but you’ll also get hit with a 10% early withdrawal penalty — in addition to the income tax that you will have to pay on the withdrawal.

While there are a few exceptions that allow you withdraw 401(k) funds prior to the age of 59 ½ (permanent disability or a qualified military reservist called to active duty), chances are, you will face some form of penalty for doing so.

Conclusion

Although this is not an exhaustive list of every detail related to your retirement plan, I think this is probably a good place to stop. Hopefully, by now you’ve gained more clarity on the options available and have some insight on the factors that are most important to you.

And by the way, remember how I said I started saving when I first started working? Well, that money has been growing for 20 or 30 years and now I have a nice nest egg built up. I never missed the money I contributed. You can do that too.

As always, if you have questions or would like to talk in detail about your specific situation, click here to schedule some time to chat.

Cheers to a strong finish to 2017!

 

Pamela J. Horack, CFP® of Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.

 

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