This Is My First 401(k) - What Should I Do?

Hey Pete & Damian!

I just became eligible to start a 401(k) account at work. This is the first time I’ve ever had a 401(k) and I’m not sure what I should be doing. Can you help?

Thanks!

— Nevaeh

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Hi Nevaeh,

Congratulations! A 401(k) is a great way to put money aside for your retirement. However, as you’ve learned, there are a few things that need to be addressed when starting your account. I want to share a few considerations you’ll want to think through as you start your journey.

How Much?

One of the most common questions we get is, “how much should I be saving for retirement?” There isn’t a simple answer I can give you because it’s based on a number of things (your age, how long you plan on working, how much money you want to spend in retirement, etc…). However, the minimum we suggest you set aside is the amount that qualifies you for all of your employer match. If you don’t contribute at least that much you’re turning away free money. Ideally, you’re contributing considerably more than that, but it’s a starting point. Russell Investments conducted a study a few years ago and found out that most people need to save at least 12-15% of their income to have a shot at the retirement they envision. If you’re getting started with saving a bit later in your career, you may need to bump that number up a bit higher, even.

Additionally, I suggest setting your contributions up to increase each year automatically. Try to time the contribution bump with when you typically get your raises so you won’t notice the impact of the increase. You won’t have to remember to make the change to your contributions and you’ll reap the benefits in the end.

Where?

Many employers offer their employees the option to save into a traditional 401(k) account or a Roth 401(k) account. If you’re not familiar with the differences between those two accounts, here’s the scoop:

A traditional 401(k) account is funded with contributions that haven’t had income taxes taken out of them. Those contributions will grow in the account until it’s time to use the money in retirement. When you take the money out (called a distribution), you’ll need to pay/withhold income taxes on that money, usually at the time of distribution.

A Roth 401(k) works in the opposite way. You pay taxes on all of your current income and then make a contribution to your Roth 401(k). The money will continue to grow inside of the account until it’s time to take a distribution in retirement. Good news, you won’t have to pay any income tax on the amount taken out because you’ve already paid the government their share.

Which should you choose? Again, there isn’t a simple answer. Ask yourself these questions, though. First, do you think you’ll be in a higher or lower tax bracket when you retire? If you think you’ll be in a lower tax bracket (which generally means a lower income) saving into the traditional 401(k) might make sense as you’ll pay lower taxes in the future. If you’re at the beginning of your career and expect your income to grow in the years to come, contributing to a Roth 401(k) might be more advantageous right now.

In the end, I’m much less concerned about where you’re saving for retirement than I am if you’re saving the appropriate amount to reach your goals.

What?

There is a good chance that you will need to decide how you’ll invest your money. There are two main options: a DIY solution and one that is managed for you. The DIY solution will require you to choose investments on your own, monitor them, and make adjustments when necessary. It can be done reasonably successfully by anyone who wants to put the time and effort into learning how to manage their investments. It can be intimidating and potentially overwhelming, but a well constructed investment portfolio doesn’t have to be complicated and intricate to be successful. Sticking with the basics and having the discipline to not let your emotions dictate your investment approach can work out quite nicely.

The second solution involves something typically referred to as “target-date funds (TDF)”. TDFs are an all-in-one type of solution. The investor chooses the fund that most closely matches their desired retirement date (2040, 2045, 2050, etc…) and the investment company handles the rest. The chosen fund will automatically invest the contributions into a number of other mutual funds in an allocation that makes sense for the amount of time remaining before your anticipated retirement. It’s a clean, no-hassle way to make sure your money is being invested reasonably appropriately on your behalf. Are target-date funds as efficient and inexpensive as a portfolio that you could put together yourself? Probably not, but that’s not why they exist. They’re built for the person who doesn’t have the time, resources, or desire to handle this part of their life themselves. They may not be the absolute best option, but you could do much worse than using target-date funds.

I’m happy to discuss more of the ins and outs with you, Nevaeh. Just getting started can be a big accomplishment, but let’s make sure you’re doing it the right way and are set for the long-term. Congratulations, again!