401(k) quickstart guide: 6 simple rules
We cut through the complexity so you don’t have to
For all the complexity in its internal systems, a computer has become a very simple plug-and-play experience. Pull it out of the box, follow a quick setup, and you’re on your way.
If only the same could be said for workplace retirement plans. After more than a decade of concerted effort by 401(k) plans to simplify the process, choosing one can still seem daunting, given all the options. So, here’s a 401(k) Quickstart Guide that will direct you through the handful of good choices.
Choose the Roth option if it’s offered. Most plans offer the ability to save in a Roth or a Traditional 401(k). Yet to reach your peak earning years? A Roth is smart. Been saving for years in a Traditional? Consider doing some Roth saving now. Retirement pros recommend “tax diversity.” Every penny from a Traditional account will count as taxable income. Money you can spend in retirement without owing tax — that’s what a Roth gives you.
Contribute at least 10% of your salary. If you waited until your 30s to start saving, set your contribution rate at 15%. Seem steep? Not even a series of massive bull markets will get you to a secure retirement if you’re saving 3% or 5%, which is where plenty of plans start with auto enrollment.
If you get a company match, be careful making it part of your contribution math. For example, if you get a 3% match, you can get to 10% by setting your personal contribution rate at 7%. But most plans don’t grant you immediate ownership of the match. Ask about match vesting schedules and understand them.
Choose the TDF if you’re under 50. An unfortunate 401(k) design flaw is the overabundance of investment choices: 21 different mutual funds, or collective investment trusts, on average. Thankfully, there’s likely a great plug-and-play option: a target date fund, a one-and-done option that makes investing choices for you, based on your age. A 2040 TDF is for someone who expects to retire around 2040, for instance.
A TDF will hold a mix of stock funds and bond funds appropriate for the period until you hit your retirement date, and it also takes care of another chore: rebalancing. Be warned: Beyond age 50, choosing a TDF requires more consideration.
Choose your own funds, instead? Go low-cost. If you prefer building your own portfolio, drill down to the offerings that have the lowest expense ratio. That’s an annual fee deducted from a fund’s performance. A fund that gains 10% and has a 1% expense ratio will credit your account with a 9% gain. A fund with a 10% gain and a 0.10% expense ratio will credit your account with a 9.9% gain. Over 30 years, a $10,000 initial investment will be worth about $40,000 more.
Typically that will be from index funds. Study after study shows that actively managed funds rarely beat index funds. Even when a manager does well for a given year, or two, over time that manager does not keep it up.
Rebalance your funds. Once you set the percentage of your portfolio you want in stocks and the percentage in bonds (and maybe cash), you need to periodically check to see if the markets have pulled you off your plan. You can move money in and out of funds to get back to the right balance. (TDFs do this automatically.) Some plans offer a free automatic rebalance tool. Without rebalancing, your portfolio can be too aggressive when a bear market hits, or too conservative as a bull market starts up.
Don’t touch the money until you retire. Sounds obvious, but poor design makes it all too easy to cash out an account. When you leave a job, at any age, you are allowed to cash out all or part of your 401(k) account. That can be tempting. Or, if you have yet to build up $5,000 and leave a job, the plan will often cash you out even if you would prefer to keep it there.
A cash-out can trigger a tax bill, potentially add a 10% early withdrawal penalty, and, most important, raid money from your future retirement. A few thousand dollars you spend today could be tens of thousands of dollars if left to grow. Whenever you leave a job, slow down and consider the best move for what to do with your old 401(k).