*NOTE* We talk specifically about 401ks in this article, which are used by for-profit companies. if your employer is a non-profit, governmental, educational or religious organization, you may have a different plan called a 403b, TSP or 457. Though specific details may defer among the plans, they are all retirement savings funds and function similarly.

 

The first time I thought about retirement was at the first day of my first job after college. I was 22, clueless and just moved down to San Francisco.  That meant I’d be paying federal, California state and SF city taxes and thus, was poor. The 401k was through Fidelity, and I remember a packet with words that didn’t register, choosing arbitrary funds on the website and that was the end of it.

My goal for you is to not do what I did. Here is a quick and dirty guide on what to expect.

What Is A 401K?

  • Retirement savings plan designed by the IRS in the 70’s to give taxpayers (that’s you!) a way to save money and take a break on paying taxes.
  • Sponsored by an employer, meaning that your employer must offer them to you for you to participate.

The Most Beautiful Thing About This:

  • Tax breaks: If there’s one thing that sucks about being an adult it’s having to pay taxes on pretty much everything. Fortunately, both contributions and earnings in your 401k AREN’T taxed! That means that unlike other income (like say, your paycheck or earnings on investments from a regular taxable account), you don’t have to pay Uncle Sam taxes on any interests, dividends, or capital gains you get on your 401k investments.
  • Compounding: The 8th world wonder, according to Albert Einstein. The money you put into your retirement funds grows exponentially because the money your funds make (those earnings or dividends you don’t have to pay taxes on) are used to buy more funds, which then make more money, which buys more funds, rinse, repeat x infinity. Amazing.

Compounding vs No Compounding. $$$$ > $$

Traditional Or Roth?

Usually, you get two options for your 401k- a traditional or Roth. Here are the key differences:

Traditional 401k Process: Pay taxes later

  1. You contribute to your Traditional 401k with money from your paycheck before it’s taxed. You know how the government takes a slice of each paycheck for federal and/or state taxes, Medicare and social security? The IRS lets the amount you put into your 401k slide – you don’t have to pay taxes on it, so the amount of tax you pay overall is LESS!
  2. Your money then grows tax free. As your investments make you money, you don’t have to pay taxes on any earnings!
  3. When you retire and start withdrawals, you pay taxes.

Roth 401k Process: Pay taxes up front

  1. You contribute to your retirement account with money from your paycheck after it has already been taxed. This means you have to pay income tax on the amount you put into your Roth 401k.
  2. Your money then grows tax free. As your investments make you money, you don’t have to pay taxes on any earnings!
  3. When you retire, you don’t have to pay taxes on withdrawals because you’ve already paid them before putting it into the Roth.

Deciding between Traditional and Roth is a little bit of a crapshoot. You don’t really know which one is better, unless you can tell the future. Until then, use this tool to help you decide which is best for you:

If you’re still conflicted and your company allows you to split up your contributions to both accounts, then do it to hedge your bets. The most important thing is just to contribute.

What Do I Need To Do?

  1. Contribute at least the amount of your employer match because that’s free money. Then, contribute as much as you comfortably can- most experts recommend 15%.
  2. Choose funds that have a low expense ratio. The expense ratio is the cost the investment companies charge to manage your investment. The lower, the better. A 1.5% and .15% expense ratio make a massive difference in a lifetime of earnings. Don’t just pick funds with fancy names, like I did.
  3. Choose index funds that represent a broad range of the market, like the S&P 500. This is a low-risk and sure-fire way to make money throughout the course of your working life.

Wanna Be An Overachiever? The Fem Fiscal Way

Max your 401k out! The maximum amount you can contribute in 2018 is $18,500. That means you don’t pay taxes on that $18,500, and that $18,500 compounds year after year, growing at an exponential rate! And even if you aren’t able to contribute all of $18,500, put in as much as you can, as early as you can. No matter your age, today is considered early.

“The best time to plant a tree was 20 years ago. The second best time is now.” – Chinese Proverb