You were hired. The signing bonus was paid, LinkedIn congratulates you, and HR just sent you a lot of onboarding papers. In this pile, there is one very important document – the 401(k) enrollment form. Well, maybe the most important one this year.
Here is a hard truth which people in their late twenties and early thirties realize too late. Each month when you miss an opportunity to enroll in the 401(k) is a missed chance to earn money. Yes, you read me correctly – it is missed guaranteed return on investment which cannot be compared with any savings accounts.
Your Opportunity to Optimize Your 401(k) Is Shorter Than You Think
Usually, companies give you a period of 30 to 90 days to enroll in 401(k) after you start working. Some employers auto-enroll you in 401(k) at the default contribution rate which is 3%. Sounds great until you realize that you do not reach your needed contribution rate with such a conservative number. In case your employer uses Fidelity, Vanguard, or Charles Schwab as the plan administrator, you will definitely receive an email with credentials of your account in your first week. Do not ignore it and procrastinate reading it as you do not want this email to become just another email about company picnic.
Log in as soon as possible. It takes around fifteen minutes and most of 401(k) providers made this process relatively easy. You simply need to choose your contribution rate, investments, and beneficiary.
What Contribution Rate You Should Choose
Opinions are different here, so I am going to share my advice. Being a mid-level executive and earning between $85,000 and $150,000, I would advise you to contribute 10% to 15% of your gross salary. Yes, it sounds tough when you see this on your paycheck, but the tax advantages, along with other reasons, make it worth it. And you will get used to it faster than you think.
The maximum contribution rate allowed by IRS in 2024 is $23,000. You should try to reach this limit, not just aspire to it. Also, if your employer offers a match rate, then make sure you contribute at least the same amount as the match rate. For example, you get 50% match on the first 6% of your salary. Thus, with your $120,000 salary and 6% contribution rate, you will get $3,600 per year. It is 50% of the instant return on investment before the market even starts.
To neglect the full match rate is like refusing the raise from your employer. Nobody in his or her right mind would do it.
Selecting Investments for 401(k)
It is the point where most people stuck and just put all their money into money market fund due to its stability. But remember, you are in your twenties or thirties. You have at least three decades before your retirement. Time is your biggest asset and to invest too conservatively now is risky.
Most of the plans allow you to choose target-date funds which automatically adjust your asset allocation depending on your age. For example, funds like Vanguard Target Retirement 2055 or Fidelity Freedom 2060 are totally fine. They are not sexy, they will not make you feel like Wall Street guru, but they work and the expense ratio is quite low.
Or you can create simple three-fund portfolio including the U.S. total stock market index fund, international stock index fund, and bond index fund. Be aggressive in your stock allocation while you are young, 90% stocks and 10% bonds. Rebalance annually and do not check your 401(k) balance every day as it leads to regrettable decisions.
Which Option You Should Choose – Traditional 401(k) or Roth 401(k)?
Most plans now offer you an option of choosing the Roth 401(k). If you choose the traditional 401(k) option, your contributions are pre-tax which reduces your taxable income, but you will have to pay taxes when withdrawing your money during the retirement. With the Roth 401(k), you make after-tax contributions, but your withdrawals will be tax-free.
Knowing the fact that you are a younger executive and your income is expected to grow in the future, the Roth 401(k) option will fit you better. You pay the taxes at the moment when your tax rate is comparatively low. The math gets complicated in case when your income rises above the higher brackets, but for the most of younger people, Roth 401(k) is the right choice. Of course, you can make part of your contributions to Roth 401(k) and another part to the traditional 401(k) in order to hedge your bets. Some financial advisors suggest such approach.
Several Things No One Ever Tells You
First of all, your 401(k) from the previous job is not just forgotten. You can roll it over to the 401(k) of your current employer or to the IRA offered by Schwab or Fidelity. It is technically okay to leave your 401(k) there, but you can forget about it and will not have so many investment options as with the rollover. It takes you a phone call and some paperwork.
Also, pay attention to the vesting schedule of your employer match rate. It is not always yours right away. Some companies use the graded vesting schedule according to which you gain 20% of the ownership each year and become a full owner after five years. Others use the immediate vesting. It depends on your company and makes a huge difference in terms of planning your job tenure.
Try not to borrow money from your 401(k) even though this feature is available in most cases. The interest rate looks attractive on the paper, but you borrow money from your future and the loan becomes due immediately after you leave the company. It is a trap hidden under the guise of a good thing.
The Boring Math That Will Change Everything
Let us do some math as numbers speak louder than the advice. You are 28 years old, you earn $110,000 and contribute 12% with a 4% employer match rate. Thus, you contribute approximately $17,600 per year in your 401(k). Assuming the 7% annual return on investment, you will have around $2.2 million by the age of 60. Increasing contribution to 15%, you will accumulate closer to $2.7 million. The difference between two is the price of the slight tightness in your budget in your thirties.
Compound interest does not depend on your emotions. It quietly works and generates generational wealth from modest contributions.
Conclusion
Please, do not wait for the perfect moment to optimize your 401(k) completely. Enroll today, select the target-date fund if you are not sure, set the contribution to the percentage covering at least the full match rate and then revisit it in six months when you will have enough time to adjust. The worst strategy of managing your 401(k) is postponing this process until “eventually.”