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Everything You Need to Know About 401(k) Plans

By: David Bach  |  Last Updated: September 30, 2020
Financial Expert & 10x New York Times Bestseller
IN THIS ARTICLEThe major benefits of 401(k) plans
Roth 401(k) plans
How much should I save for retirement?
How should I invest my retirement money?

An essential part to building wealth is paying yourself first — that is, consistently setting aside a portion of your income into a pre-tax retirement account. If your company offers a 401(k) plan, you’re in luck, because it’ll make paying yourself first incredibly easy to do.

A 401(k) plan is considered the mother of all retirement accounts. Here’s what you need to know.

The major benefits of 401(k) plans

1. You get major tax breaks. You contribute pre-tax money to a 401(k), so the more you add to your account, the more you reduce your taxable income and, therefore, your tax bill. You also don’t pay taxes on any of the returns you earn over the years (unlike regular investment accounts, which are taxable). You only pay taxes when you withdraw your earnings and contributions, but you’ll likely get taxed at a lower rate since, as a retiree, your income tends to drop, which puts you in a lower tax bracket than when you were fully employed.

2. In 2020, you can put as much as $19,500 a year into a 401(k). (If you’re 50 or older, you can contribute $6,500 more in “catch-up contributions,” for a total of $26,000.)

3. Your contributions are automatically deducted from your paycheck. That means, once you sign up, that’s it! You don’t have to do anything. The percentage of your income that you elect to contribute will be automatically taken out of your paycheck and put into your 401(k) plan, where it will grow effortlessly over time.

4. Your company may match a percentage of your contributions. Many employers offer a “401(k) match” and will match your contributions up to a certain amount. That’s essentially free money!

5. By consistently contributing to your plan every time your paycheck lands, you’ll enjoy the miraculous benefits of compound interest. The money in your 401(k) plan is invested — when you open your plan, you need to select an investment (the account itself is just a holding tank), but more on that later. The important thing to note here is that over a lot of time, money compounds dramatically, so the sooner you start contributing to your retirement plan, the better.

A few notes on 401(k) plans:

  • You can’t withdraw your money before age 59 ½ without paying a 10% penalty. Also, you can’t keep your money here forever — IRS regulations require you to make what’s called a required minimum distribution generally starting the year that you reach age 70 ½. If you don’t take the minimum distribution, you’ll owe a penalty. (Though, Congress suspended required minimum distributions for 2020 in response to the Covid-19 pandemic — meaning, instead of having to take money out this year, retirees can keep their investments growing.)
  • Many people mistakenly assume that if their company offers employees a 401(k) plan, they’re automatically included in it. This is almost never the case! At most companies, if you don’t sign up for the plan, you’re not in it. You should be able to join at no cost. Check with HR to make sure you’re properly signed up. If you’re not, enroll ASAP. (Some companies won’t let you join their 401(k) plan until you’ve worked there for some minimum amount of time. If this is the case for you, find out when you will be eligible and mark the date on your calendar.)
  • When you enroll, check to see if you have the option of setting up “auto-increase,” which allows you to increase your contributions by a certain percentage every year (or however frequently you want). This is a great feature, especially if you’re starting off with a smaller contribution and want to eventually work your way up to saving more.

Roth 401(k) plans

In 2006, the Roth 401(k) plan option was introduced. It allows you to invest after-tax dollars (that means no tax deduction up front) into the plan — then, your money will grow tax-free until you take it out at age 59 ½ or later, just like a regular 401(k) plan. When you take your money out, however, the distributions are tax free.

If you’re young and your taxes are low, this account can make sense for you, since you’re paying taxes on this money now and not later, when you might be in a higher tax bracket. If you’re in a high tax bracket right now, I would pass on this type of account and continue with the regular version.

If you can’t decide which way to go, you can always choose to use both options (if your plan allows you to) and put some money into a tax deductible 401(k) plan and some into a Roth 401(k) plan. Then you’ve covered both tax bases. Typically, people who do this split their contributions 50/50. 

A Roth 401(k) plan does not have any income limits (unlike a Roth IRA), so high income earners can use this type of plan.

How much should I save for retirement?

As for how much to contribute to your 401(k) plan, I want you to aim to save 10% of your gross income. Of course, more is always better.

If you can’t afford to save 10% right now, contribute enough to get the full match if your company offers one. It’s OK to start off slowly, saving a smaller percentage of your income at first and gradually working your way up to where you need to be.

Even if you think the best you can do right now is to save just 1%, don’t let that stop you. Anything is better than nothing. At the same time, try to be ambitious. However much you think you can afford to save, do more. If you think you can save 4%, save 6%. If you think you can save 10%, save 12%. Most of us tend to underestimate how much we think we can manage. As a result, we wind up low-balling ourselves — and our futures.

How should I invest my retirement money?

So you’ve enrolled in your 401(k), but now comes the really big decision: How are you going to invest your retirement money?

Your 401(k) account itself is just a holding tank. It’s the investment you select that determines how fast your money will grow. Whether it earns 1% or 10% depends on how you invest it. With a retirement account, it’s critical that you invest wisely, not gamble.

The best way to do this is to follow the old advice about not putting all your eggs in one basket. In other words, you need to diversify, meaning, instead of investing all of your money in just one or two places, spread it around. This doesn’t mean opening a bunch of different retirement accounts. This means building a diversified portfolio of stocks, bonds and cash investments in one retirement account.

The bulk of companies offer what are called a target date mutual funds, which will help you build a portfolio that makes sense for your situation. These funds have a specific year in their name (for example, the 2030 fund or the 2040 fund), the idea being that you selected the fund closest to your projected retirement date. They help you select an investment fund that will be professionally managed with a “target date of retirement.” Say you want to retire around 2035. You simply select the fund with “2035” in it. Then, the fund manager builds a diversified portfolio, broken down between stocks, bonds, cash, global investments, etc. The fund will be automatically rebalanced and the risk in your portfolio will be reduced as you get closer to retirement.

Pre-tax retirement plans are where all wealth starts — and if your employer offers a 401(k), you have zero excuses to put off saving for your future. If you haven’t done so already, enroll in your 401(k) plan today and start contributing. Your future self will thank you.

Read next: Everything You Need to Know About 401(k) Plans, IRAs and Other Retirement Savings Accounts