401k Basics for New Grads

This article is from our friends at Captain401, written by Damian Davila.

Congratulations on your first job! With student debt looming and the thrill of getting a regular paycheck for the first time, you may decide to put retirement savings on the back burner and delay contributions to your employer-sponsored 401(k). Let’s talk about why it’s a good financial strategy to start contributing right away and how you can make the most out your first 401(k) plan.

So, What’s a 401(k)?

A 401(k) is an investment account that is used exclusively for retirement savings offered through your employer. It’s a very common way to save for most Americans because of its tax benefits. Throughout your working years, you can make contributions by setting aside money from your paycheck, before or after taxes. In this article, we’ll focus on making contributions to your 401(k) with pre-tax dollars, since that’s more commonly offered by most companies.

401(k) options (eligibility, financial advising services, pre-/post-tax, etc.) vary from company to company so talk with your HR department to learn more about the retirement plan offered by your employer specifically.

The Best Time to Start Saving for Retirement is Right Now

Reason #1: The Earlier You Start, the Less That You Have to Contribute

This isn’t your grandfather’s retirement saving account, so more and more financial advisers are recommending that young workers set a nest egg goal of $2 million instead of the old $1 million. Let’s assume that you invest in an index fund with an average annual return of 7% compounded annually and you want to retire at 65. Here’s a breakdown of how much you need to contribute every month:

* However, the IRS caps 401(k) contributions for workers under age 50 to $18,000 in 2017.
** However, the IRS caps 401(k) contributions for workers age 50 and over to $24,000 in 2017.

The more that you wait to start contributing to your 401(k), the more that you’ll have to contribute once you get started, and the more difficult it gets.

Reason #2: Contributing to a 401(k) Lowers Your Taxable Income

Whether you worked while you were in school or not, saving on taxes was probably not high on your list of priorities. Now that you are (hopefully) getting a bigger paycheck, you’ll also have to pay more in taxes. One major way to make big cuts to your annual tax bill is to contribute to a 401(k).

Let’s say you’re making $45,000/year. As a single filer with no deductions, you would owe roughly $6,988.75 in federal taxes in 2017. Here’s how much you can save in federal income taxes with a 401(k):

Contributing to your 401(k) doesn’t just increase your chances of a comfortable retirement, but also puts more money back in your pocket by reducing your tax bill every year.

Once you decide to contribute to your 401(k), how can you make the most of your money? Follow the three tips below.

3 Tips for 401(k) Beginners

1. Invest in Stocks

When you invest your money in a 401(k), you’ll get to to pick from a variety of funds, and there are two main types: stocks and bonds. Stocks are higher risk with higher potential reward, whereas bonds are low-risk with low potential reward. Depending on how far away you are from retirement, you may want lower risk (if you’re retiring soon), or you’re in it for the long haul and want to build up your gains (new grads, that’s you!). Most financial advisers suggest young retirement savers allocate roughly 90% of their investments to stocks and 10% to bonds.

2. Look for Low-Cost Index Funds

So, you know you should go after stocks, but which ones? Take the advice of one of the most successful investors of all time, Warren Buffett. In his 2013 letter to Berkshire Hathaway shareholders, he tells individual investors:

“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

And the empirical evidence backs up Buffett’s advice: a study conducted by Morningstar concluded that the expense ratio (or annual cost) of a fund is the only dependable predictor of future performance, even more so than Morningstar's own popular star rating system.

Make sure to seek out funds with the lowest fees (AKA expense ratios) you can find. Even small percentage point differences of .05% can make a big difference -- remember, just as interest compounds, so do fees.

3. Take Advantage of Employer Matches

Your employer may or may not match your 401(k) contributions. Often, this is considered part of a compensation package as an employee benefit, so they probably told you about this from day one (if not, ask!). A “match” is essentially your employer agreeing to put some extra money in your 401(k) for you, as long as you put some in yourself -- typically, they “match” your contribution, so that if you put in 3%, they’ll put in another 3% as well.

If your employer offers a match, this is basically a tax-free bonus they’re offering you, so be sure to adjust your contributions to qualify for the match.

The Bottom Line: Take Action Today

In sum, an employer-sponsored 401(k) is one of the most important but under-utilized perks of having a full-time job that may young workers neglect. The financial decisions you make in your 20s can have a huge impact on your options and financial security down the road, so be sure to do your research and start good saving habits now!