You recently graduated and got a job, congrats! You start to go through your benefits package and you stumble upon the 401(k) account. You read things like matching, vesting period, and contribution limits, and you’re getting more and more confused. Should you even bother contributing? Here’s some information on the 401(k) basics and some advice.

401(k) basic terms

Let’s clear up some terminology.

  • contribution: the percentage of your salary you put into the 401(k), usually pre-tax.
  • contribution limit: limit set by the IRS how much you could contribute per year.
  • match: the percentage your employer will contribute to your 401(k), usually based on how much you contribute to it. For example, the employer will match 100% up to 5% of your salary, which means they will match you dollar for dollar if you contribute 5% to the 401(k). This is free money!
  • vesting period: the amount of time it takes for the money in the 401(k) to be truly yours. This usually applies to the company’s match. For example, you might have a 2-year vesting period. This means that you will need to work 2 years at your employer before the match is yours.
  • Distribution: when you take money out of your 401(k) and use it as retirement income

Different types of 401(k) accounts

There are a few different ways you can contribute to your 401(k), depending on whether your company offers these.

  • Pre-tax or traditional 401(k): You contribute pre-tax money into the 401(k) account, which lowers your taxable income in the current year. The contributions and growth are taxed when you take money out. At age 59.5, you can start receiving distributions.
  • Roth 401(k): You contribute post-tax money into the 401(k) account, which does not lower your taxable income in the current year. Your contributions and growth are not taxed when you take it out. At age 59.5, as long as the Roth 401(k) is at least 5 years old, you can start receiving distributions.

How do I choose?

Choosing between a Roth and a traditional 401(k) is kind of like choosing between a Roth and traditional IRA. If you think you will have higher taxes in the future, it’s a good idea to contribute to the Roth version. But, if you think taxes will be lower because maybe you’ll need less money during retirement, then a traditional 401(k) might be good.

I chose to do the traditional 401(k), because I think during retirement, we will likely have a paid-off mortgage, perhaps no more childcare costs, and I don’t anticipate us living in a high COL area.

How much should I contribute?

As much as you’re comfortable with and your budget permits it. At the very least, you want to contribute to the match limit. So, if your employer will match you 100% when you contribute 5% of your salary, you contribute 5%. Any less and you’re leaving free money on the table. Remember, the invested amounts include the contributed and matched amounts, and will earn compounding interest.

If you can contribute more, go ahead. Remember the 401(k) limit. In 2021, it’s $19,500, and it will increase to $20,500 next year. So calculate how much the limit is as a percentage of your pre- or post-tax income, and contribute up  to that percent. Any time you get an increase in your salary, think of increasing your contribution percentage.

Be careful not to reach the contribution limit before the year is over, because you might forfeit some of your company’s match. This depends on the company, as some might transition your contribution to post-tax amounts and continue to match it. For example, where I work, if I reach the limit with my pre-tax 401(k), they will automatically transition the rest of my contributions to post-tax money and continue to match my contributions.

Once you’ve set your contributions, make sure to choose your investments wisely! I recommend following a similar investment approach as your IRA accounts, which means index funds if available, or mutual funds with low expense ratios.

My own 401(k)

I started my current postdoc in June 2020. The national lab I work at offers a great 401(k) package. They give me 6% of my salary before I contribute any amount. Then they also match 2/3 of my contributions up to 6% of my salary. So if I choose to contribute 6%, they will match 4%. However, the account has a long vesting period of 3 service years (which is a bit different than actual calendar years according to company policy), so I’m stuck here for a while :).

I started contributing 6% of my salary to get the full match, and then increased it to 10% about six months in as our budget adjusted to the COL of Northern California (eek). I tried 21% one time, but it was too much. Now I’m at 15%, but I’m still not 100% settled on it yet.

My 401(k) is held at Fidelity. I invested an index fund that tracks the S&P 500, a bond index, The Fidelity Growth Company Commingled Pool fund which has a higher expense ratio but great returns (so far), and an international equity index fund to get some exposure to the international market. Since June 2020, my 401(k) has grown to about $29,500 as of October 2021. My vested balance is about $15,000 and the match will vest in June 2022.

I might get rid of the bond index as I’m nowhere near retirement and want to focus on growing my portfolio. And I’m hoping to stick with 15% contribution, but we might have to lower that in 2022 because my salary is staying the same, while healthcare premiums and cost of living are increasing. At the very least, I’ll continue to contribute 10%.

Final thoughts

Don’t think of 401(k) as depriving yourself of your current income. Remember that a traditional 401(k) is using pre-tax dollars, so if you decide to not contribute to your 401(k) in order to have a larger paycheck, you won’t see all of this money. At the very least, contribute to get the full match! That’s a 100% return on your investment, for free. And don’t forget to invest your contributions. Otherwise, your money is just sitting there, doing nothing to make you more money.

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