You’ve started a new job and during the onboarding process the HR person guiding you mentions the company 401k plan.[1] Because she is a Human Resources professional and not a financial advisor she can’t tell you much about it other than that it exists. With some companies, it is an automatic sign up and you have to opt out if you do not want to contribute. With other companies it is voluntary. But you ask yourself two questions, should I invest and what investments should I choose?
For most employees, the answer to the first question is yes, you should invest. The future is uncertain and it is wise to save for the unknowns ahead. You may want to retire someday. Many financial planners recommend saving 10-15% of your income. While retirement may be one goal worth saving for, there are other savings objectives. You should aim to have 3-6 months of living expenses saved in your emergency fund. This should be in a high interest savings account and ready for true emergencies. You also may be saving for a house, your next car, or some other big expense. Try to put at least 5% of your income into the 401k and continue to work toward your other savings goals. Many companies have a formula for matching employee 401k contributions. If you company has a match try to put in enough to get the match. The company match is free money so take advantage of it.
The amount you contribute to a 401k is not taxed in the year you put it in. It will also grow tax free until you start taking money out. It is important to remember that 401ks are retirement accounts and the earliest you can take the money out without penalty is age 59½. There are exceptions, but typically, if you take money out before age 59½ you will have a 10% penalty in addition to the income tax you pay for the withdrawal amount. Your company may also have a Roth 401k option. With this option you pay income tax in the contribution year but future withdrawals will be tax free as long as you’re over 59 ½ and the money has been in the Roth 401k for over 5 years. As with 401ks, there are exceptions to avoid the penalty for early withdrawals from Roth 401ks. If you are willing to pay the taxes now, the Roth 401k option may be for you.
So what should you invest in? Typically, 401k investment options are mutual funds. A mutual fund is a collection of stocks, bonds, or both. These funds can be actively managed with a financial professional picking the investments, or index funds that are tied to an index.[2] Actively managed funds are more expensive to hold than index funds. Many 401ks default to a target date mutual fund. The target date is the year closest to your retirement. Most fund companies now have target date funds from 2025 to 2070 in five year increments. These funds are a mix of stocks, bonds, and cash that are more aggressive in the early years and become more conservative as the target date approaches. This is a set it and forget it choice and works well for many people. If your plan has other options, you may prefer to pick your own funds. Try for a mix of funds that give you a diversified portfolio. Your financial advisor can help you pick the best funds for you.
Retirement is a goal for many people. A well-funded 401k can go a long way toward eliminating financial stress when you reach that goal. The earlier you start contributing to your company 401k the greater that nest egg will be.
[1] If you work for a non-profit, a school or hospital, it may be a 403b plan. The principles discussed are the same.
[2] An example would be the S&P 500. An index of the 500 largest US companies.