For Retirement Savers

Setting up a 401(k)

Lesson in Course: Finance at work (beginner, 8min)

Our job offers a 401(k). How do I set it up?

Eureka!

What it's about: Knowing the details of our 401(k) plan to get the most out of it.

Why it's important: Maximizing our 401(k) benefit is going to help us reach our retirement goal.

Key takeaway: We should review our 401(k) elections every year to make sure we're on track for retirement.

401(k) accounts make saving for retirement much easier. Since they are only available through our employer, we'll have to enroll in a new 401(k) whenever we switch jobs. 

Unfortunately, the details and enrollment for these plans are often shuffled into the overwhelming stack of onboarding paperwork. It's easy to forget the options we selected or remember if we've provided all the required information.

Here's what we need to know about our 401(k) plan:

Requirements and eligibility

The U.S. passed the Employee Retirement Income Security Act of 1974, known as ERISA, to standardize retirement plan practices. It spells out the minimum plan requirements and eligibility. While ERISA sets the standard, companies can offer exceptional perks by going above and beyond these minimum requirements.

ERISA sets requirements for 401(k)s

Age

Usually, we have to be at least 21 years old to participate in a 401(k). We are allowed to contribute until the last day before retirement.

Employment

In 2019, 401(k) accounts became eligible for full-time and long-term part-time employees when the Setting Every Community Up for Retirement Enhancement (SECURE) Act became law. The requirement for full-time employees is 12 months of service. After which, all employees older than 21 must be allowed to participate in the 401(k) plan.

Many employers offer 401(k)s right away

For part-time employees, anyone who's worked at least 500 hours in the last three consecutive years (and are 21) must be allowed to participate in 401(k) plans.

Income 

The IRS limits how much income counts toward calculating our contributions as a percent of our income. For example, the IRS limits the amount of compensation eligible for 401(k) contributions to $290,000 in 2021. The income limit doesn't exclude anyone who makes more than $290,000 in a given year. Instead, every dollar beyond $290,000 is not eligible for contribution.

Vesting

Many employers will match our 401(k) contributions, but that doesn't mean that we own that money right away. Sometimes we have to work at the company for a certain period before it's entirely ours. We call this vesting. A vesting schedule is a timetable to receive the money that an employer added to our 401(k). The vesting schedule is to reward employees who stay at the company. 

Vesting schedules can span across multiple years

Companies often create vesting schedules with a cliff or graded structure. A cliff means we don't own any of our employer's contributions until after a certain period, but we'll own all of it afterward. In a graded vesting schedule, we own parts of the contributions over time.

Vesting examples

The table shows a 3-year cliff vesting schedule and a 6-year graded vesting schedule. A 3-year cliff vesting means we don't own any of our employer's additions to our 401(k) until after 3 years. After that period, all of the contributions become ours. A 6-year graded schedule means we own 20% after 2 years, 40% after 3 years, 60% after 4 years, 80% after 5 years, and 100% after 6 years.

Not all companies require vesting, and some offer employee-friendly schedules. Since vesting applies only to the money contributed by our employer, we always own 100% of our pre-tax contributions.

 
 

Plan elections

Whenever we start a new job that provides a 401(k) plan, we need to make several decisions. If we are existing employees, we can reconfirm our choices at any point.

We aren't required to contribute to a 401(k)

Opt-in or opt-out

The first choice to make is if we want to participate in the 401(k) plan. Barring life emergencies, this should always be yes (opt-in). Even if it's only a few dollars per paycheck, every little bit counts towards retirement and lowering our taxes for the year.

Pre-tax or post-tax

Some companies offer Traditional and Roth 401(k)s. Contributions to Traditional accounts are pre-tax, while contributions to Roth are post-tax. 

Traditional vs Roth

Traditional: If we want to lower how much we pay in taxes today. Pre-tax means we make our contributions from our paycheck before paying income taxes. For example, if we contribute $10,000 to our 401(k) and our salary is $80,000, we would only pay income taxes on $70,000. However, we will need to pay income taxes when we withdraw the money in retirement.

Roth: If we want to lower how much we pay in taxes during retirement. Post-tax means we make our contributions from our paycheck after we pay income taxes. So, we won't have to pay any taxes when it's withdrawn in retirement.

Income deferment

Income deferment is how much of our salary or yearly earnings we want to save. Most 401(k) plans show the amount contributed from our paycheck as a percentage of wages. For reference, 5% is a great starting point for most folks. We can go higher, say 10%, to save more aggressively. Some 401(k) plans allow us to pick a flat dollar amount instead of a percentage.

Beneficiaries

Beneficiaries are those who receive this money if something happens to us. 

Beneficiaries are usually immediate family

Plans automatically assign us as the primary beneficiary, but we can select a contingent beneficiary. If we're married, our spouse defaults as the contingent beneficiary. We can also choose to add any family member, including parents or kids. When adding beneficiaries, we need to provide each beneficiary's social security number and birthdate.

Investment choices

Most 401(k) accounts are very similar to our brokerage accounts, allowing us to pick investment options. All 401(k)s offer mutual funds, while some 401(k)s offer ETFs. Professional investment managers have made it easy for us to save for retirement by creating target-date funds. These are simple investments that provide investment strategies based on the year we plan to retire.

 

Automated elections

Sometimes, there isn't paperwork for us to fill out or make all of these choices upfront. Some employers use an auto-enrollment process, making default selections for us. Auto-enrollment is convenient for employees and increases participation, but we should double-check them to fit our financial circumstances. 

Automated settings make our decisions easier

Here are some standard auto-enrollment features that we can change at any time:

  1. Opt-in vs. opt-out — some companies will automatically enroll us into the 401(k) plan, giving us 30 to 90 days to opt-out. They will open a 401(k) account for us if we don't opt-out.
  2. Automatic contribution — our employer might automatically set a 3% salary deferral as our contribution. Companies do this to increase participation rates and lower administrative fees.
  3. Auto-investment — many employers and plan administrators use a default investment for our contributions, like a target-date fund based on our date of birth.

Actionable ideas

It's a good idea to review your elections every year and update them to match your needs. If it's been a while, log into your 401(k) account to ensure all of the information is up to date and your deferral rate is enough to reach your retirement goal. Setting quarterly reminders helps you keep track of your savings and the account's performance. It's also an opportunity to make changes to your investments. 

Supplementary materials

Eligibility and participation information can be found on the IRS website
Check it outhttps://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-eligibility-and-participation