Learning how to start a 401(k) is one of the most important things you can do to prepare for retirement. Today’s article reveals the essentials for starting one.
How to Start a 401(K) on Your Own and Prepare for Your Golden Years Now
Step 1: Start by Understanding What It Is
What is a 401(k)? A 401(k) refers to a kind of retirement savings account that you can get via your employers.
In a 401(k), you put aside a specific amount of money from your salary monthly to invest for retirement. You can choose to invest in a number of different financial assets like stocks, mutual funds, and bonds.
Income derived from any 401(k) account investment isn’t taxable until you withdraw it. The most ideal time to withdraw the money is after you retire.
For self-employed individuals, there’s another kind — Solo 401(k).
Wondering how to start a 401(k) if your employer doesn’t offer it? Since a 401(k) should be sponsored by your employer, you can’t start a 401(k) on your own, but an alternative is to open an IRA.
Step 2: Know Why You Should Start a 401(k) Retirement Plan
Compelling reasons help people focus and persevere in doing things that are very important but are hard or boring. That’s why having very compelling reasons for starting – and continuing – a 401(k) is very important.
The most important reason why you should have one is to help you in saving for retirement so you can ensure all your retirement needs will be met. And the only way to do that is to start setting aside money as early as possible.
Remember, the earlier you start a 401(k) or any other retirement savings account, the more money you’ll get upon retirement. That means you can meet more of your needs, and even wants, too.
Another reason to have a 401(k), which is specific to employer-sponsored plans, is the employer-matching contribution scheme. Under employer-matching 401(k) plans, your employer can match your contributions, the amount of which depends on the plan.
In effect, employer contributions let you use free money to grow your retirement savings account even more.
And the last reason for having a 401(k) is lower income taxes. This is because 401(k) contributions are tax-deductible, which means they’re legitimate income tax deductions.
However, it’s not tax-free. This is because you’ll eventually pay taxes on these when you withdraw from your 401(k) during retirement.
Step 3: Determine Your Contribution Amount
There are two things that can affect your 401(k) contribution amount:
- Legal limit
- Personal limit
As of 2019, the IRS-set annual 401(k) contribution limit is $19,000 for people below 50 years old. For employees over 50, there’s an additional annual catch-up contribution limit of $6,000, increasing the annual limit to $25,000.
But for many people, their personal limit is less than $19,000 or $25,000. If you’re one of them, let your personal income and budget be your guide.
Remember, even the smallest regular savings is better than having none at all.
Another important factor to consider is your employer’s matching contributions. As mentioned earlier, employer match contributions can increase your total annual contributions in a 401(k) account.
And if you’re already contributing $19,000 or $25,000 annually, there’s good news! The annual combined contribution limit for employer-matching plans is $56,000 if below 50 years old and $62,000 if over 50.
If you’re under an employer-matching 401(k) plan, you must contribute the minimum amount needed to qualify for such a plan.
Step 4: Pick Your Investments Wisely
Oftentimes, employees choose according to potential returns on investment. However, choosing based on this alone isn’t wise.
This is because of the risk-return principle that governs investments. This principle says that the higher one’s expected returns are, the higher one’s financial risks are, too.
So, it’s important to also consider your risk tolerance or appetite. Here are five common types of funds available in most 401(k) plans, ranked from lowest to highest risk:
- Money Market Funds: Very low risk but their average returns are so low that they barely match inflation rates. With such low returns, you’ll have a hard time growing your investments to the point they can suffice for retirement.
- Bond Funds: These types of funds are like Money Market funds, but with longer maturities and better returns. However, they’re also relatively low risk and as such, their average annual returns aren’t that high either.
- Mixed Funds: These types of funds contain a combination of money market instruments, bonds, and stocks, the ratios of which depend on the fund’s risk profile. Mixed funds can help you get a mixture of average returns superior to inflation with lower risk than stock investments.
- Target-Date Funds: These are mixed funds but with a twist — they have a target ending date in mind. In the beginning, these types of funds are more aggressive (higher proportion of stocks than fixed income) and as the funds near their target dates, they become more conservative (higher proportion of fixed income securities than stocks) to preserve meaningful gains from earlier and more aggressive investments.
- Equity Funds: These are funds that invest exclusively in equities or shares of stocks. They provide the highest potential returns but also have the highest investment risk among the five types of 401(k) funds.
Step 5: Check the Fees
If you think a 401(k) is free, you’ll be disappointed. Because you’ll have your skin in the game for a really long time, think until retirement as these fees can add up to a significant amount over time.
Fortunately, you can compare and check how much 401(k) fees can cost over time using an online financial calculator. Before jumping right in, check the associated fees for each type of fund with your employer.
Step 6: Avoid Making These Mistakes
Since opening and maintaining a 401(k) can be pretty simple and straightforward, many people make seemingly harmless mistakes that can potentially impact their retirement fund over the long run. Take good care to avoid making the following mistakes so you won’t be one of them.
a) Ignoring Your Employer’s Matching Contributions
As mentioned earlier, an employer’s matching contributions can significantly increase your total annual 401(k) contributions without you having to contribute more. Ignoring or not taking advantage of this will make you miss out on a much higher retirement fund later on.
b) Ignoring the Default Investment Option
Many 401(k) plans provide a default investment option, and if you don’t check what this option is, there’s a risk that the investment broker will put your contributions in a fund type that you don’t want.
c) Forgetting to Regularly Monitor Portfolio Composition
By this, we mean not checking in on one’s investments to see if it needs rebalancing, such as changing portfolio composition to make more aggressive or conservative. Over time, your risk preference or tolerance may change and more often than not, older people become more conservative with their investments.
d) Neglecting the Roll Over When Changing Employers
While it may seem like common sense to bring along one’s retirement fund when quitting a job, many make the mistake of leaving behind their 401(k)s with their former employers and eventually forget about them. You can open a new 401(k) with your new employer via a direct rollover, which spares you the burden of taxes and penalties.
e) Rolling Over to a Lesser Quality Retirement Account
Sometimes, a former employer’s 401(k) plan is much better than the new one’s. In some states, 401(k)s are better than IRAs, too.
In these cases, it may be better to leave your 401(k) where it is when you move to a new employer or state, so evaluate wisely.
f) Over-Investing in the Employer’s Shares of Stocks
Investing too much of your 401(k) in your employer’s stocks prevents you from diversifying your investment risks properly. Even if your employer’s a very stable company, failing to diversify to other securities with more growth potential can prevent your retirement savings account from growing optimally.
g) Loaning Against a 401(K) for the Wrong Reasons
There are two unpleasant things that happen if you take out a loan against your 401(k): you receive less retirement money and suffer from double-taxation.
Borrowing against your 401(k) reduces its current investible amount, which reduces the amount you’ll get from your future retirement funds in the long run.
The income you’ll use to pay back your 401(k) loan is taxable income, making that part of your 401(k) already tax-paid. When you withdraw from it later on, it’ll be taxed too, hence the double taxation.
Starting a 401(k) isn’t rocket science. With sufficient understanding of the basics, you can easily start and maintain a 401(k) to prepare for your retirement.
What type of fund do you want to start for your 401(k)? Let us know in the comments section below.
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