Enrolling in a 401(k) Plan – How to Make Informed Decisions

The process of enrolling in a 401(k) plan can seem intimidating, especially for those new to managing personal finance or retirement planning. However, with the right approach, you can overcome these fears and make confident, informed enrollment decisions. In truth, 401(k) enrollment involves just requires two basic but important basic decisions – how much to save and where to invest – and most plans offer some form of professional investment advice to make appropriate investing easy.

To make informed 401(k) enrollment decisions, understanding the benefits and features of your plan and the factors to consider when making contribution and investment choices for your account is crucial. This understanding can help you significantly reduce your future retirement's out-of-pocket cost. To guide you through this process, I recommend a four-step approach that will empower you to make the best decisions for your financial future.

Step 1 - Understand the Benefits of a 401(k) Plan

Participating in a 401(k) plan offers several benefits that can positively impact your financial security. Some notable benefits include:

• • Pre-tax Contributions - Contributions to a 401(k) plan are typically made with pre-tax dollars. This means the money is taken out of your paycheck before income taxes are applied, reducing your taxable income for the year.
  • Employer Matching - Some employers will match your 401(k) contributions, up to a certain percentage of your salary. This is essentially free money that boosts your retirement savings without any extra effort on your part.
  • Tax-Deferred Growth - Contributions made to a 401(k) plan with pre-tax dollars grow on a tax-deferred basis. This means you don't pay any taxes on the dividends, interest, or capital gains from the investments in your account as they accrue. You'll only pay taxes when you start withdrawing funds in retirement.
  • Roth Contributions - Some 401(k) plans allow Roth contributions, which are made with after-tax dollars. While Roth contributions don't reduce your taxable income in the year you contribute, withdrawals in retirement, including earnings, can be tax-free when certain conditions are met.
  • Automatic Savings - Participating in a 401(k) plan encourages regular saving for retirement. It's easy to procrastinate or spend money on other things, but automatic contributions from your paycheck help you prioritize your future financial security.
  • Investment Flexibility - 401(k) plans usually offer a range of investment options, allowing you to tailor your portfolio to your risk tolerance and retirement goals. They also tend to offer a foolproof way to help you invest appropriately like target date funds.
  • Compound Interest - By starting to save early and consistently contributing to your 401(k), you can take advantage of compound interest. This means your contributions, along with any earnings, will generate additional returns over time. The earlier you start, the more time your money has to grow.
  • Portability - If you change jobs, your 401(k) account is portable. You can either leave it in your current plan, roll it over into a new employer's plan, or transfer it to an Individual Retirement Account (IRA) with no tax consequences.
  • Legal Protections - Assets in 401(k) plans are typically protected from creditors and bankruptcy, offering a layer of financial security.

Step 2 - Understand the Features of Your Plan

All 401(k) plans allow you to defer a portion of their wages until retirement on a tax-advantaged basis. Most offer additional benefits. Details about the benefits specific to your plan can be found in the following documents:

• • Summary Plan Description (SPD) - Describes your rights, benefits, and responsibilities under the plan in plain language.
  • Participant Fee Notice – Describes how to direct the investment of your account, the fees and expenses that may be deducted from your account, and the fees and expenses that apply to your investment options.

You should receive a copy of these documents on or before the date you become eligible for plan participation.

Step 3 - Decide How Much to Contribute

Deciding how much to contribute to your 401(k) plan depends on several factors including your financial goals, your current financial situation, and your retirement plans. Here are some considerations to determine the right amount:

• • Maximize Employer Match - At a minimum, try to contribute enough to get the full employer match, if available. A match represents an immediate return on your investment. For example, if your employer matches 50% of your contributions up to 6% of your salary, you should aim to contribute at least 6% to take full advantage of the 50% match.
  • Contribution Limits - For 2024, the IRS limits 401(k) contributions to $23,000 for those under 50, and those 50 or older can contribute an additional $7,500 as a catch-up contribution, totaling $30,500.
  • Financial Goals - Consider your retirement goals. Think about the kind of lifestyle you want in retirement and use retirement calculators to estimate how much you need to save to fund that lifestyle. This can help you decide how much to contribute each year.
  • Affordability - Review your budget to determine how much you can realistically afford to contribute without compromising your current financial health. Remember, contributions are typically made with pre-tax dollars, so increasing your contribution might not reduce your take-home pay as much as you might think.
  • Age and Retirement Timing - If you started saving for retirement later in life, you might need to contribute more aggressively compared to someone who started saving in their 20s. Conversely, if you plan to retire early, you might also need to save more aggressively.
  • Financial Stability - Ensure you have an emergency fund and manage high-interest debts before maximizing your 401(k) contributions. It's important to balance saving for retirement with maintaining financial stability in the present.

A common recommendation is to aim to save from 10% to 15% of your income for retirement, including any employer match. However, the best amount depends on your personal circumstances and retirement goals. Consulting with a financial advisor can also help tailor your retirement saving strategy to fit your specific needs.

Step 4 - Choose Investments for Your Account

Investing your 401(k) account appropriately throughout your working years can dramatically lower the out-pocket cost of your future retirement. Investing a 401(k) account appropriately involves constructing - and maintaining – an investment portfolio that balances growth potential and risk of losses. Striking this balance is important. Otherwise, you could miss out on gains by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when older.

You must properly apply three investing principles invest a 401(k) account appropriately:

• • Asset Allocation - Involves allocating your investment portfolio among different asset categories, such as stocks, bonds, and cash based on time horizon and risk tolerance.
  • Diversification - Involves selecting investments with uncorrelated returns for your asset allocation. This way, if one investment is declining, others are more likely to grow, or at least not decline as much – minimizing the risk of large losses.
  • Rebalancing - Involves periodically buying or selling assets in a portfolio to maintain a desired asset allocation.

If you’re like most 401(k) participants, you will need professional help to properly apply these principles throughout your working years. Fortunately, there’s a good chance your 401(k) plan offers one or more of the three major forms of professional investment advice available today:

• • Fund-based advice – delivered by a mutual fund. A Target-Date Fund (TDF) is the most popular form. To invest appropriately, you simply need to invest 100% of your account in the TDF that best matches your target retirement date. 
  • Human advice - delivered by a financial advisor.
  • “Robo” advice – delivered by a computer algorithm - a set of rules that constructs an investment portfolio for you based on responses to a questionnaire. 

Not investing your 401(k) account appropriately can be a costly mistake, so you want to get professional help if you need it. An Aon Hewitt study found professional advice increased the median investment returns of 401(k) participants by 3.32% annually.

Do Your Future Self a Favor by Enrolling Today!

The priciest thing you will probably buy in your lifetime is retirement. Perhaps you’ve never thought of “buying” retirement, but that’s exactly what you do when you contribute to a 401(k) plan – you’re paying now for income in retirement. When you consider that income may need to last 10, 20, even 30 years, it’s easy to understand why retirement is not cheap.

Given the cost of retirement, saving for it can seem futile – especially if you can’t afford to save much annually. In truth, compound interest can make retirement affordable for nearly anyone able to make annual contributions to a 401(k) plan over decades, even if the annual contribution amount is small. Our 4-step enrollment process can help you get started on the right foot.