Congratulations! You’ve been hired to your first full-time position at a company that has great benefits, including an employer-sponsored 401(k) plan. You’re truly an adult now. Or maybe this is the second company you’ve worked at that has provided an employer-sponsored 401(k) plan. Or the third. Or the fourth? We’re not counting. The bad news is that you’re still an adult.
And as an adult, it’s your job to make sure you’re using that plan properly. A 2019 survey by ValuePenguin found that only 37% of Americans understand how 401(k) programs work. Furthermore, a full 41% of Americans don’t know that they pay fees for an investment manager and other services when they participate in a 401(k) program, according to the Government Accountability Office.
“It’s the price you pay for having access to that particular investment,” says Kevin Mahoney, a certified financial planner and the host of the Financially Well podcast.
What else do you need to know about your 401(k) to make sure you’re getting the most out of it? We asked three financial experts.
1. Think of your 401(k) as compensation—and act accordingly.
Although you likely won’t use your 401(k) until you’re ready to retire, you should think of it as more than just an investment: It’s part of your compensation, especially if your company offers to match a certain percentage of what you contribute. “Your company’s match is not only ‘free money,’ it’s also a part of your entire compensation package,” says Amber Miller, a financial planner based in Minneapolis. “Just like your salary or health care benefits, the 401(k) match is yours.”
To understand exactly what you’re owed, look at your Summary Plan Description, which your company is federally required to provide during the benefit program onboarding process. This document will tell you the size and timing of employer matching descriptions, as well as how to qualify for hardship withdrawals, among other details about the program. (If you missed or ignored the document when it was first presented to you, ask your human resources department or manager for another copy.)
It is important to read this document closely, notes Miller, because all matching programs are different. For example, some companies may require a minimum deposit before their matching program kicks in. And some companies use complicated calculations (they match 100% of the first 3% of your salary that you contribute, and then 50% of the next 6% of your salary), which may mean that you have to contribute more of your salary than you think to receive your full match.
“It’s important to understand your maximum match because companies often don’t require you to contribute anything, so you could be missing out on what is, effectively, a yearly raise in matched funds,” Miller says.
2. Determine the appropriate asset allocation.
When you enroll in a company’s 401(k) program, you will receive a few investment fund options chosen by the company. These will generally include options with a range of offerings of stocks, bonds and sometimes the employer’s own stocks. Some funds will include a higher percentage of stocks and others will include more bonds.
There’s been a lot written about how much risk you should incur in your investment portfolio given your age—for example, some experts say that you should use the “100 minus your age” rule for determining the percentage of stocks you invest in. But Mahoney notes that you should also carefully look at the fees, or expense ratios, charged by each investment fund you are being given access to. Fees, he notes, can range from 0.2% to 5% and help pay for customer support, legal fees and transaction processing. A fee is charged yearly, which means that as your investment grows, you’ll continue to pay the same percentage every year. So there’s a big difference between paying 1% and 5% annually, especially given that you will likely not touch the money for many years, if not decades.
“You should minimize your expense ratios as much as possible while still achieving your investment goals,” Mahoney says. One safe bet, he notes, is choosing a target date fund, which will adjust the ratio of assets you are invested in as you get closer to retirement age. “Target date funds are a great option for people who don’t feel safe investigating all of the options,” he says. That is, if your company-sponsored 401(k) program offers one—and it doesn’t charge an unusually high expense ratio.
Another thing to note, Miller adds, is that if you don’t choose a fund option, the default for your company may be to keep the 401(k) in cash. In that case, “your money won’t even be invested unless you select something,” she says.
3. Adjust your contributions for inflation.
The IRS sets a limit on how much an employee can invest in a 401(k) program every year, which makes sense considering that 401(k) contributions come from pre-tax income. However, the maximum amount they allow is adjusted for cost of living. In 2020 and 2021, for example, the maximum amount allowed was $19,500, but in 2022, the maximum amount allowed is $20,500. This is a notable jump that reflects the current rate of inflation.
Even if you’re not on track to contribute that entire amount, you should still increase the amount you contribute to your 401(k) every year, says Bobbi Rebell, author of Launching Financial Grownups and a personal finance expert at Tally. “The good news is, many plans allow you to adjust your contribution at any time,” she says. “So you can always change your mind and lower the contribution amount.”
Furthermore, you can make annual “catch-up” contributions if you are 50 or older (up to $6,500 in 2022).
4. Consult with a trusted source when making decisions.
There are—or should be—a lot of professional resources available to you when you’re making decisions about your 401(k). For example, the human resources department at your company should be able to answer any questions you might have, not matter how simple.
If you can, Mahoney recommends turning to a trusted source—like a colleague, supervisor, parent or mentor—who can help you to parse the information. Of course, you can always hire a financial advisor who can help you make smart decisions about your 401(k) that will complement your other financial plans, such as starting a family or buying a house.
However, the important thing to remember is that you shouldn’t let a 401(k) plan intimidate you to the point where you don’t use it correctly, or at all. “Someone who picks blindly might not benefit in the same way as someone who does their research,” Mahoney says.
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