What is a 401(k)? Basically it is a retirement savings plan sponsored by your employer that has tax advantages. Specifically it allows you as an employee to contribute certain amounts of money each year pre-tax, i.e. before taxes are taken out of your paycheck.
Taxes are eventually paid once the money is withdrawn — which is usually beneficial since most people have less taxable income in retirement than during their working years. Often, though not always, some amount of your contributions are “matched” by your employer.
The less-than-sexy name comes from the section of the Internal Revenue Code in which 401(k)s are described.
How Much Should I Invest in My 401(k)?
The usual answer to this question is as much as you can up to the annual limit (which was $17,500 in 2013 for people 50 years and younger, with even more for those 50+). Every dollar you invest in your 401(k) has a double payoff: it goes towards your future retirement and it lowers your current taxable income.
Even if you can’t save up to the annual limit, most financial advisors recommend at least contributing enough to reach your employer’s maximum match (if they match), since that’s essentially extra money they’re adding to your salary.
What Should I Invest In?
This is often the most complicated part of a 401(k). Our advice is to talk to a financial advisor if at all possible. Most employers provide access to an advisor for free or at a discounted rate, as do many community organizations. A good advisor will be able to tailor investments to your personal circumstances and also provide advice on the particular funds offered by your employer. One tip: whenever you talk to an advisor make sure to ask them how they’re compensated. Do they make money by selling certain things? If so, take their advice with a grain of salt.
If you’re planning on doing it yourself an important thing to consider is proper asset allocation — basically mixing the investments in your portfolio in such a way as to take into account variations in risk and reward. There are a lot of competing theories out there about asset allocation (and even a debate about whether you need to diversify your portfolio at all) so make sure to do your homework.
This set of charts from Vanguard is good for visualizing how different types of portfolios can perform. Fidelity has a useful set of calculators to help determine what sort of asset allocation might work for you, as do most other investment firms. If you’re looking for a tool not affiliated with a financial institution, try this one from CNN Money.
Photo by 401(k) 2013 via Flickr.