This post has 3 parts. Part 1, I explain what a 401(k) is. Part 2, I explain how you contribute to a 401(k). Part 3, I explain why you should contribute to a 401(k).
Part 1. What the heck is a 401(k)
A 401(k) is a retirement savings account sponsored by employers. In order to contribute to a 401(k), you need to be employed.
When you contribute to your 401(k), you are really contributing to your company’s 401(k) fund. Your 401(k) account is part of this fund, and is restricted to the investment options of the fund. Usually the options include mutual funds and the company’s stock. Most likely you will not be able to invest in individual securities such as individual stocks and bonds. This restriction is imposed so that your investment is always diversified to some degree.
Most 401(k) funds also allow you to invest in a fund-specific portfolio with different levels of aggressiveness. Higher aggressiveness means higher risk and higher potential return.
For example, say my 401(k) has 10k in it. I decide to invest 20% of it, or 2k, in a small-cap stock fund. My company has chosen a certain money manager for this option, say Vanguard. So in reality I invest 2k in Vanguard’s small-cap stock fund through my company’s 401(k) fund. I also invest another 30%, or 3k, in my company’s “most aggressive portfolio”; I do not know who manages this portfolio, and I let my company decide that for me.
Since your company’s 401(k) fund invests a large amount in these mutual funds, they are usually able to negotiate a lower investment fee than the rate you would be charged if you invested in the same funds on your own. Your company is also responsible for finding the best investment options for you; so don’t be surprised if your company changes the money managers from time to time. If my company finds out that Fidelity has been doing a better job managing their small-cap stock fund than Vanguard, they may decide to give Vanguard the boot and invite Fidelity in.
So that’s basically how 401(k) plans work.
Part 2, How you contribute to a 401(k)
Again, you have to be employed to contribute to a 401(k), because your 401(k) is sponsored by your employer. In order to contribute, you declare how you want your money to be allocated. For simplicity, let’s say 60% in mid-cap stock fund, and 40% in inflation-linked bond fund.
Next, you declare what percentage of your base salary you’d like to contribute to the 401(k). Let’s say 10%, and your base salary is 50k per year.
Next, you choose between Traditional 401(k) and Roth 401(k). More on this later, but for now, let’s assume you choose Traditional 401(k).
Let’s also make the funny assumption that you get 25 paychecks per year; most people get 24 (2 per months), but 25 makes numbers rounder.
So each paycheck corresponds to 2k in base salary. Since you contribute 10% to your 401(k), for each paycheck issued your 401(k) contribution increases by $200. For 25 paychecks per year, you contribute 5k to your 401(k) per annum. But, each time a contribution is made, you start collecting investment returns on the contribution right away. If this is the first year you contribute to your 401(k) and the economy is doing well, at the end of the year your 401(k) account value will be slightly higher than 5k, say 5.2k.
Next year, you get a huge promotion and get your base salary increased to 60k, then each paycheck is 2.4k, and $240 of that goes into your 401(k). Over 25 paychecks, the contribution is 6k. At the end of the year, you’ll have something like 12k, the result of this year and last year’s contributions and investment returns.
The result of these calculations is … If you keep going at this rate for 40 years, you’ll probably retire millionaire! (f not multi-millionaire ;) )
Part 3. Why put my money in there?
Some employers match employee contribution up to a certain amount, usually a percentage of your base salary. So the obvious first step is to contribute at least the amount that would maximize the employer contribution. For example, if my base salary is 50k a year, and my employer matches 50% of contribution up to 3% of my base salary, I will contribute at least 3k a year; at this rate my employer will contribute 1.5k a year, the maximum amount: 50% of my contribution and 3% of my base salary. Free money is not too bad, is it?
Using my previous example where I contribute 10%. With my employer contributing another 3%, I will have 13% of my base salary contributed to my 401(k) each year. More chance of retiring millionaire!
Some employers do not match, but you should still contribute to their 401(k), if not because of lower fees and well-researched investment options, then simply because it is a very convenient way of saving and investing for retirement. For most people, setting aside some amount periodically is more comfortable and more guaranteed than making a huge contribution sum at once. It’s the same reason you pay off a house over 30 years, not in 1 month.
I realize this post is already long enough to confuse you, so I’ll give you time to leave any questions or comments. The next posts will cover the IRA, and the Traditional vs Roth. If you have questions on these, they may get answered in a future post!
Richard (Hiep Tran)