Ahhh, retirement! Those days of traveling with your husband, playing with grandchildren, sleeping in, and relaxing after 40+ years of hard work, raising children, and paying your dues. Sounds good, doesn’t it?

But what if I told you that 24% of Americans have less than $1,000 saved for retirement, more than 50% have less than $50,000 and nearly two-thirds are worried that they won’t have enough money to pay for things like healthcare-related expenses in retirement.

Gulp! There goes the carefree swinging on the porch, holding hands with my husband, and tousling my grandchildren’s hair.  I’m going to have to work until I’m 100.

Breathe.

I’m going to share with you one amazing way to set yourself up for retirement bliss – your 401k.

What is a 401k?

People get so overwhelmed by financial “stuff” and I blame part of it on the stupid names. Many things, like the 401k, are named after the section of the tax code where they described.

How much more appealing would it be if the 401k were called “The Magic Money Maker for a Blissful Retirement?” Or something shorter but just as amazing?

Because really, the 401k is kind of magical.

To put it in super simple terms, a 401k is a retirement account. Okay, there’s a little more to it than that. It is a retirement account that your employer offers to you.

Normally, with the 401k account, the employer offers the account as part of the employee benefit package and often will match up to a certain percentage that an employee decides to have withheld from her paycheck.

So, for example, say Julie makes $40,000 a year and decides to have 10% of her PRE-TAX (this is important!) income taken out and invested in her 401k. Her employer says they will match 100% for the first 3% and 50% of the next 3%.  What???

This means that Julie will be contributing $4,000 per year to her 401K and the employer will contribute an additional $1,800.

FREE MONEY. Insert free money dance

And the money that Julie contributes, as well as the money that her employer contributes, is not taxed until Julie withdraws the money at retirement. So, Julie lowers her taxable income and begins growing her retirement account.

Who is eligible?

If your employer offers a 401k plan, check into the specifications with your supervisor or HR department.  The IRS states that the strictest a 401k can be is to require that the employee be at least 21 years old and have worked one year (minimum 1,000) before participating in the plan.  Many employers, however, let their employees start participating sooner than that.

Why should I have one?

Well, besides the FREE MONEY that we talked about earlier that you may receive from your employer (Check with your employer because each company offers something a bit different!), you should take advantage of your company’s 401k for a few reasons:

1. Tax advantages

The main reason that many people tout retirement accounts is because there are tax advantages to having one.  With a 401k, you use pre-tax dollars to fund it, which means that you lower your taxable income for the year.  You will have to pay taxes when you withdraw the money, but most people are in a lower tax bracket at retirement than they are when they are paying into the account.

Also, you can take advantage of high returns on the money that you would have paid in taxes.  (I still think the best retirement strategy is to have a mix of pre-tax funds invested in a 401k and have post-tax funds invested in another retirement vehicle, like a Roth IRA.)

Related post: What the Heck is a Roth IRA and Why Do I Need One?

2. Retirement is expensive

As humans, we tend to put things off until the last minute or until we have an emergency.  Most people avoid buying life insurance even though we know we should.

Retirement is not cheap.  While you may not expect to live the high life when you are retired, you do want to be comfortable and you may have to live off the money you have saved for retirement for 20 or more years.

So, take advantage of the time that you have now and get started today.

3. Great way to get started investing

Investing can seem really complicated or scary. Investing in your 401k can be a great way to get started in the world of investing.  Because there are (a lot of) funds set up that are already balanced depending on the amount of risk you want to take, you don’t have to know much about investing to make your investment decisions.

Setting up your 401K for Success

Okay, now you know that you want to set up your 401k.  Let’s take the mystery out of it with five simple steps to setting up your 401k for success!

Step #1 – Research your employer’s specifics

Check out the employee handbook or set up an appointment with someone from Human Resources to go over your company’s specific offering for their 401k. Nearly every company is different.

Some companies offer matches. Some don’t.  There are some that will match up to 3%, others up to 5%, others more still. Some companies have a vesting schedule, which can be enough to make you want to skip the 401k elections and have a glass of wine instead.

Basically, vesting means that the employer portion of the money in your 401k (not the portion that you contribute) is not actually yours, at least not completely, until you have completed a certain number of years of service.

I worked for a company that had a five-year vesting schedule.  It went something like this:

One year – 20%
Two years– 40%
Three years – 60%
Four years – 80%
Five years – 100%

That meant that I would only get 100% of the money that my employer contributed to my 401k after having worked five years with the company. When I changed jobs, I had worked four years with the company, so I received 80% of the employer’s contribution into my 401k account.

What you want to make sure is that you understand your employer’s specific offering and take full advantage of any FREE MONEY coming your way.

Step #2 – Decide how much you want to invest

First, you need to take a look at your budget and decide what you can realistically afford to set aside for retirement. If your company has a match and your budget can handle it, try to invest at least as much as your company is willing to match into your 401k.

By doing so, you’ll be taking full advantage of the benefit your employer offers. But, I’d encourage you to try to invest more.  A good number (again, if your budget can handle it) is 10% of your pre-tax income annually.

Step #3 – Choose your investment options

This is where many people get overwhelmed.  How do I know what investment options to choose? Each employer chooses the company they’d like to work with for their retirement plans, so you won’t have a say in the company.
Each company offers different funds.  Some offer several options and others have fewer options.  There are two main things you want to evaluate when choosing funds:

1. Fees

Different funds have different fee schedules and they can vary A LOT.  So, you want to pay close attention to the fees you will be charged in each of your funds.

All of the funds are going to have fees, called an expense ratio, but you can compare fees of similar types of funds and choose one that meets your goals and also has lower fees.

2. Risk

Different funds vary greatly in the amount of risk that they have. Stock funds are riskier but also generally have higher long-term returns than bond funds, which are less risky but with lower returns.

So, you want to think about how much time you are going to have the money invested. If you are not going to retire within the next 10 years, you can afford to have your money invested in a larger percentage of stock-based funds.

Even within stock funds, there are different levels of risk/reward. Some of the most common categories of stock funds are:

Large-cap
Mid-cap funds
Small-cap funds
Growth Funds
Foreign Funds

Large-cap funds

The large-cap funds generally have the large easily recognizable corporations that have been around for a long time. They are stable and don’t generally have large swings in the stock market.

Growth funds

A growth fund, on the other hand, can have start-ups that may grow quickly and make a lot of money or may go out of business, so they are much more volatile.

Foreign funds

Foreign stock, depending on how “healthy” the US stock market is at the time, is generally a bit more volatile than the other funds, but can also help to diversify your 401k.

You never want to put all of your eggs in one basket. Don’t find your favorite retail store and decide to invest all of your money into it.

Bond-based funds, as we said earlier, are more stable. They can include corporate bonds or Treasury bonds. Corporate bonds normally give a higher return than the government Treasury bonds.

When deciding how much to invest in stock-based funds versus bond-based funds, you can use a simple rule that many in the investing world use – the 110 rule. Subtract your age from 110 and that is how much of your portfolio you should be investing in stock-based funds.

Julie is 33 years old, so she should invest 77% of her 401k in stock-based funds and 23% in bond-based funds.

This rule, while definitely general and flexible, helps to give an idea of how we can balance our investment portfolio.

Step #4 – Evaluate performance

While I don’t think you need to (nor is it healthy to) check your 401k every day or every week, you should evaluate your performance at least annually. Don’t be scared if you have seen large swings in some of your funds. This can be normal.

What you’ll want to do to evaluate your performance is compare your fund against other funds in the same category. If it seems to be very different, you may think about changing the fund.

You’ll also want to rebalance your accounts. Each year, you should take into account your age, fund performance, any changes in fund managers that may affect performance, and any change in fee schedules when you make your decision to re-balance your account.

Step #5 – Pay yourself first

Finally, each time you get a raise or changes jobs and get a better salary, re-evaluate the percentage that you are setting aside for your 401k and decide whether you can give more.

We tend to spend close to everything that we receive (or more, sometimes). So, if we decide to invest the money before we even see it in our bank accounts, that can help us to not fall into the trap of spending on things we don’t need.

That’s it! 5 easy steps to setting up your 401k for success. First, you will research your employer’s specific retirement plan benefits and make sure you understand them.

Then, you will take a good look at your budget and decide how much you can invest. You’ll make your investment elections trying to balance risk and reward. You’ll evaluate your performance at least every year and make changes as necessary.

And finally, you will make saving for retirement a priority and increase the percentage you are setting aside whenever you get a raise or a better job.

Now, go get that 401k set up! Your retired self will thank you while she is sipping a cocktail on vacation!

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