Signing up for a company sponsored 401k is a great way to invest money. What is a 401k? It is a retirement savings plan which has favourable tax outcomes; the captain gains, dividends, and interest earned within the 401k are not taxed until withdrawn. That sounds too good, so what is the catch? You can only make withdraws, without penalty, after 59 1/2 years of age. Let us explore more on what a 401k is.
If your company sponsors a 401k plan, then the odds are you are already in it. Most companies have automatic enrollment, and you can only opt out if you choose to do so; the reason why they set you up automatically is because they want to help you take control of your financial well-being. Usually on the first day of your employment you are enrolled in a mutual fund, which investment strategy depends on your age. If you are young and nowhere near retirement, the mutual fund will contain riskier investments- containing all equities. On the other hand, if you are close to retiring, the company will set you up with a mutual fund that mainly invests in fixed securities, which are less risky. Automatic investing makes sense, because the company wants its employees to retire living a comfortable lifestyle, and a sure way to do that is enlist you automatically. In fact, most companies will give you a bonus if you do contribute to your 401k plan.
The company I work for will match 25% of 6% of your contributions. That is awesome. But in order to get 100% of the 25% matching, you must work at the company for a set amount of time; in other words, you need to vest the company’s contribution. For instance, if you leave after the first year, you do not get anything. But if you work for 2 years, you get 20%. And then it gradually maxes out at 100% at year 5. So this type of company bonus encourages its employees to stay as long as possible to get most out of their 401k contributions. Ok, so how do you put money in?
Your company will automatically enroll you in their 401k plan- if they have one. And if you are automatically enrolled, the company will usually take around 6% of your pre-tax income and put it into the 401k. You can call your company’s HR, or go on the company’s benefits website to change the amount you want to put in. You can also change the contribution type from pre-tax to post-tax income. Why would you want to do that? First if you put money in pre-tax, you cannot take it out without penalty until you are 59 1/2 years of age (there are some other exclusions as well, but in rare cases). If you put your money in post-tax then you are allowed to take out the amount you put in post-tax, but not the capital gains, interest, or dividends without penalty. Additionally, you can only have a maximum of $16,500 contributed per year to your 401k, and $22,000 if you are over 50 years old. So what can you invest your money in?
All company sponsored plans have a set amount of mutual funds you can invest in. This has three implications. First, you cannot buy individual stock with your 401k contributions; unless you are a pro, this does not matter because funds are better than stock when you want to diversify your investment. Second, you might hate/love the mutual fund choices. Sometimes the company picked mutual funds will suck. But other times you will get a crazy good deal. For instance, my company offers a Northern Trust S&P Index Fund that has an insanely low operating percentage ratio (OER), which is basically how much you have to pay to maintain funds operations. As a rule of thumb, if you are investing in an index fund the lower the OER the more you will make in return. But that will be covered in another article. Finally, the company will pay for your administrative fees associated with the investment account. This is important if you do have much money in your 401k; most mutual fund accounts will charge and administrative fee if you do not meet a certain dollar amount threshold invested.
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