Signing up for your 401k? What you Need to Know

Signing up for your 401k can be complicated – but it’s probably not the most difficult thing you’ll do this month. The most important thing is to simply get it done so that you can let it run on autopilot while you build up savings and focus on other things.

If you’re not sure where to start, here’s an outline for opening your account.

401k plans are retirement plans that help you save for the future. To learn the basics, including who controls the money and what happens when you leave your job, see What is a 401k?

Before you Start

You’re eager to get this done, but you’ll need to do just a few things before you actually sign up. This will ensure that you’re not wasting your time or money.

Getting started is the most important step.

Getting started is the most important step. Credit jakeandlindsay CC BY 2.0.

Get details on the plan from your employer. You’ll want to make sure that you’re eligible to contribute, and you’ll need to know what you’re getting into (are loans allowed, and are there any other ways to pull money out?). Find out what the average expenses are for the investments in your plan. Most of this information is available in disclosure forms that your employer is required to provide to you before enrollment, including the Summary Plan Description (SPD) and fee disclosure documents.

Next, find out how to enroll and any deadlines for enrolling. But don’t wait – do it today while it’s fresh on your mind (because you know something will come up at the last minute).

Personal Information

Now that you’re ready to sign up, it’s a matter of filling out forms. Ask your employer how to enroll, whether online, via an app, or on old-fashioned paper. Your Human Resources rep, benefits manager, or immediate supervisor should be able to point you in the right direction. On the enrollment form, you’ll start by providing basic personal information like your address, date of birth, and Social Security Number.

Decide How Much to Save

Next, you’ll instruct your employer to take money out of your paycheck and put it away for your future. You can often specify a dollar amount per month or a percentage of your pay. In many cases, a percentage of your pay is a good choice because your contributions will increase as your pay increases –the better you do, the better you do.

Get the match: if your employer matches your contributions to the plan, contribute at least enough to get all of the matching funds available. Especially for a dollar-for-dollar match, there are very few good reasons to contribute less. You’re getting free money with zero risk, and that’s not available many other places in this world. Your match might be explained as “100% of the first 3%, then 50% of the next 2%” or “dollar for dollar up to 4%.”

Make a plan: ideally, you’ll do a basic plan or retirement projection to figure out how much it takes to reach your goals. However, if that’s too much for you right now and it’s going to prevent you from doing anything (most people feel too busy to put the time into this exercise although it’s not that bad), then just get started with a number you can live with.

Comfortable number: start with as much as you can comfortably live without each month. You don’t want to get in over your head and get scared off from saving for the rest of your life, and it’s generally difficult to get money out of a 401k plan (it’s possible to get a loan or hardship distribution with some plans, but the process can be slow and problematic). At the same time, the more you contribute, the better – you’ll end up with more money later.

Rules of thumb: it’s tempting to ask what other people contribute or “what’s a good start?” but rules of thumb are generally not helpful. For a meaningful answer to the question of “how much should I contribute?” you’ll need to do a basic retirement projection. There are numerous calculators that can help with this.

Do what you can: if you run the numbers, you’ll probably find that you’re “supposed to” contribute a lot more than you can comfortably afford. Just do your best, and don’t let this prevent you from saving something. You can always make changes later, and it’ll be a lot easier if you’ve saved whatever you can.

Pre-tax, after-tax, or both: in many plans, you’ve got the option to make Roth 401k contributions in addition to traditional pre-tax contributions. If you’re indecisive, no problem – you can do both. Pre-tax contributions will be easier on your budget this month, but you’ll have to pay taxes on that money when you take it back out and spend it. Roth might allow you to prepay the taxes and withdraw everything tax-free in retirement (assuming you follow all of the IRS rules, of course). If you’re going to save 15% of your pay, you can always do 8% pre- tax and 7% Roth, or mix and match however you want.

There is generally no minimum: you can open an account with a few bucks a month or whatever is possible given your budget.

What Type of Investor Are You?

When that money goes into the plan, how will it be invested? Your plan probably offers investments that range from very aggressive to very conservative (and everything in-between).

Aggressive investors hope to grow their money as much as possible over the long term. They use aggressive investments (like investments in the stock markets) that are likely to go up and down – sometimes dramatically – over the short term. These investors hope that they will be rewarded for taking risks. Indeed, there’s a strong likelihood that they will lose money – at least temporarily – at some point in time, and they’ll lock in those losses if they sell when they’re down. Sometimes you need to sell because you need the money, and sometimes you sell because you’re unhappy about what your investments are doing. Over long periods of time, such as 10 years or more, these investments will hopefully provide strong returns and growth.

Conservative investors are less interested in growth. They are more concerned with reducing losses when the markets get crazy. They tend to use safer investments such as cash and bonds, but these investments are not completely risk-free. Conservative investors take the risk that they won’t earn enough to keep up with inflation, and bonds can lose money in several situations (such as when interest rates rise).

You can be completely on one end of the spectrum or the other, or you can find a place in between the extremes. It’s possible to go for some growth without putting all of your money at risk.

What should you do? The textbooks say that the longer you have until you need the money (presumably this won’t happen until you retire), the more aggressive you should be. This allows you to go for growth and recover from market crashes that are likely to occur from time to time. As you get closer to the day you’ll start withdrawing money, the textbooks say to ease up on your risk and shift assets from stocks to safer investments.

That’s a pretty decent textbook approach. But we don’t live in a world where the textbook is always right. You need to decide for yourself if you should be more or less aggressive than your age would suggest. Other factors are a reality.

Is there any reason you should take less risk? Will you get uncomfortable when markets crash and sell to reduce your suffering, or will you ride it out (assuming the markets ever recover and move higher than they were previously)? What happens if you lose money – would you be better off with a “bird in the hand”? How will you and your family be affected by the choices you make?

For some, it’s helpful to use a risk tolerance questionnaire to help think about risk.

Choose Investments

Now that you’ve thought about who you are as an investor, you can choose which investment to put your money into. In most 401k plans, you have several choices: you can do it all yourself, or you can have your 401k provider do some of the work for you.

We’ll assume that you’re not a sophisticated investor who wants to do all of this yourself (otherwise you wouldn’t be reading this – you’d already be researching statistics and picking funds).

There are three basic types of investments, and you probably have access to a few alternatives in your retirement plan as well:

  • Stocks represent ownership of a company. They tend to be higher on the risk/reward spectrum. The goal of using stocks is to grow your money over long periods of time (over 10 years) – knowing that you will sometimes lose money. To invest in stocks, you need to believe in long-term growth in the economy and the companies you’re investing in.
  • Bonds are like loans. You lend money to an organization (a company or government, for example) and expect to get your money back along with interest payments. The goal of using bonds is to receive income and dampen the ups-and-downs of the stock market. Bonds are traditionally viewed as having less market risk than stocks, but you can still lose money in bonds.
  • Cash is a stable investment. Instead of trying to grow your money, you’re trying to conserve it when you invest in cash. You might earn a small amount of interest, but don’t expect much. On the bright side, you are unlikely to experience the volatility that can come with stocks and bonds.

Diversification: it’s important to understand diversification. No matter what you invest in, it’s best to spread your money among various investments to reduce your risk. For example, it’s risky to only own one stock, because all of your eggs are in that one basket. If something bad happens to that company, 100% of your investment is affected. If you own multiple stocks, you won’t suffer as much if one of the companies falls on hard times. You can diversify among types of stocks, different countries, and more. You can also diversify bonds and other investments. Learn more about diversification.

Mutual funds: most plans offer mutual funds as a basic investment choice. A mutual fund is a pool of money that generally invests in numerous different investments and has an investment objective. For example, a stock mutual fund might own 100 different stocks, and a bond mutual fund might own a variety of bonds. Mutual funds can help you diversify, but you still might want to diversify among the types of funds you use. For example, you might put some of your money in US stock funds, some in overseas stock funds, some in long-term bonds, and some in short-term bonds.

A Word About Risk

It’s important to understand that investments – including “safe” money market mutual funds – can potentially lose money: you might walk away with less than you put in. It’s even theoretically possible that you’d lose 100% of your money.

Before you decide that investing is not for you, consider the alternatives. First, it’s extremely unlikely that you’d lose 100% of your investment if you’re diversified among numerous investments (using a mutual fund with hundreds of stocks, for example). If that were to happen, it’d probably be concurrent with a major world disaster, and money is the least of your worries – things like shelter, crops, and radioactive protective gear might be more important.

There’s also a risk of avoiding “risky” investments. We’ve talked about inflation, and that’s a real thing. How are you going to build up enough money to reach financial independence? It’s possible to do so by putting money into FDIC-insured bank accounts, but it’s much harder – you’ll need to save a lot more or you’ll need to work a lot longer, or both.

Past performance is no guarantee of future results, but it’s the only data we have. Look at your options, think long term (to the extent possible), and do what you can to manage all of the risks you face – not just the ones they talk about on the news. It’s easy to be scared about investing – and acknowledging risk is good. For a dose of optimism and a bigger picture view, see JP Morgan’s Principles of Investing (specifically Section 3 and Section 6).

Asset Allocation Funds

If diversifying seems like more than you want to do on your own, an asset allocation fund can handle diversification for you. You just choose one investment, and the fund will spread your money among various types of underlying investments – often buying numerous other mutual funds.

Some investors are not going to put the time into researching investments, diversifying, and repeating the process each year. If we’re being honest, most 401k participants fall into this category – they’re busy with other things, and they might not enjoy or understand the work it takes to manage investments (especially without making ill-advised choices). Asset allocation funds are a decent option for people who just need to sign up for the 401k, get a diversified investment mix, and get on with life. These funds are the easiest to use, but there’s a risk that you’re making it too easy on yourself and picking the wrong fund.

Which investment should you choose? Again, it depends on your goals and your situation. It’s always worth asking your 401k provider for guidance and education. To find asset allocation funds in your plan, look for words like “moderate investor” or “target date.”

Target-risk funds aim for a specific risk level. They might be aggressive, conservative, or moderate. The more aggressive they are, the more stock (and overseas stock) they hold. Conservative funds typically hold less stock and less-aggressive stocks, allocating more to bonds and cash. Again, to reach the desired risk level, these funds might own somewhere around 10 to 30 different underlying funds (or hundreds of individual stocks and bonds). However, you don’t need to pick those investments or create the mix – it’s done for you.

Target date funds use the same approach, but they add a twist: they can reduce risk over time. These funds typically have a year in the fund name (such as the 2055 fund), and that year helps you understand how much risk the fund might be taking. The year is the target date when you’d start spending the money from your investments (presumably the year you reach retirement age, although you can use any year you want). If the year is way out in the future, we go back to the “textbook” philosophy which says that longer-term investment horizons can take more risk. If the year is just a few years out, the fund would presumably have less risk – but most target date funds keep you invested in stocks even after your retirement date in an effort to combat inflation.

The danger of autopilot is assuming something works (when it doesn’t). These funds make it extremely easy to diversify, but they might not be built the way you want. Don’t assume a fund is safe or risky until you actually see how it’s invested. Pick a fund that meets your needs based on how it’s put together, which might mean using a year that doesn’t line up with your projected retirement year.

Learn more about target date funds and how they compare to target risk funds.

Pick a Beneficiary

You’re almost done. The next step is to choose who should receive assets in the event of your death. You’re not required to choose a beneficiary, but you might want to. The beneficiary designation makes it fast and easy for this person (or multiple people) to claim your assets: they don’t need to wait for your will or the probate process.

Override the will: be aware that your beneficiary designation trumps your will: whatever you write on a valid beneficiary form can happen before the will is even read. If your will says that Susie gets the money but your beneficiary form says that Julie gets the money, Julie gets it because the assets can skip going to your estate or probate. Make sure everything matches the way you want it to.

No beneficiary: what if you don’t choose a beneficiary? There are several potential outcomes. In some cases, your retirement plan will assign a default beneficiary. This is often a surviving spouse or next of kin, and that might not be what you want. Confirm how things work before you decide not to submit a form. In other cases, the funds will simply go to your estate. At that point, they may be distributed according to the instructions in your will, or according to state law.

Kids: parents often want to name their children as beneficiaries. That makes sense, but minors are not allowed to open most types of financial accounts. If the money goes to a child, in many cases an adult (possibly somebody you wouldn’t choose) becomes responsible for handling the money until the child reaches the age of majority – if the money lasts that long. There are ways to make arrangements before your death and improve the chances of things working the way you want. Talk with an estate planning attorney or do more research before you submit your beneficiary form.

Submit your Information

Provide the information above to your employer.

Good job! The most important step is to actually enroll in your plan and start saving money. Seriously.

Going forward, you can make changes to things if you want. It’s a good idea to revisit your choices every six to twelve months. You certainly don’t need to watch your account daily or monthly – and it might be a bad idea to do so. Remember, this is a long-term investment, not a game.

Putting money into an account is by far the most important step. If you’ve got capacity for more, it’s wise to ensure that things are working as they should.

Verify contributions: check your next few paychecks to ensure that the funds are being taken from your pay – and log in to your 401k account to verify that the money was credited to your account. In rare cases, employers miss something (and in even more rare cases, they hold on to your money), so a quick checkup is always helpful.

Watch fees: your 401k plan is not free, even if you don’t see the fees. You’re likely paying fees to money managers, recordkeepers, financial advisors, administrators, and more. Pay attention to how those fees are charged, and how much you’re paying. You should receive official Fee Disclosure documents at enrollment, and annually. The more money you have invested, the more important this becomes. Speak to your employer if you’re concerned about how much you’re paying.

Save more: almost nobody has too much money in retirement. If you’re one of the unlucky few who reaches financial independence early, well… you’re financially independent. Try to increase your contribution – even by a little – every year (or more often if you want). More is always better in this case, but even small increases add up: if you can add 1% of pay or $10 per month, it’ll help.

Don’t tinker: once you do a good job of making a plan and evaluating your investment needs, avoid making frequent changes. You should only change your investments when that change fits with the long-term plan. Timing the market is dangerous, and it’s best to just make consistent additions to your account, whether the market is high or the market is crashing. Let time work for you and avoid costly mistakes.

Update your plan: things change. At least every few years, go over how much you’re saving to see if you’re on track. Are you using the right investments for your needs? For a refresher, see How to Plan for Retirement.