Thanks to its high contribution limits and automatic, straight-from-your-paycheck deferrals, a 401(k) is an excellent way to build a sizable nest egg over time. But before you get that ball rolling, you’ve got a little bit of homework to do. In this post, we’ll walk you through how to set up a 401(k) and go over all the nitty-gritty details so you understand exactly where your money is going.

What is a 401(k)?

First things first: What is a 401(k), anyway?

Like IRAs, 403(b)s and other retirement accounts, a 401(k) is an investment account specifically designed to help you meet your savings goals for retirement. It’s governed by certain rules and regulations set up by the IRS.

So what sets the 401(k) apart from the rest of the alphabet soup? Well, for one thing, it’s sponsored by an employer — which means it’s available only to those who work for a company that offers a 401(k) as part of its suite of benefits. (There is such thing as a solo 401(k), but it’s offered exclusively to sole proprietors and business owners without any employees.)

A 401(k) allows you to make contributions, or deferrals, by setting aside a portion of your employee wages, usually measured as a percentage of your total pay. Deferrals with traditional 401(k)s are tax-deductible, meaning they won’t count toward your total taxable income for the year. Employers also can make contributions to your 401(k), which they often do in the form of a percentage match — something we’ll go over in more detail in the next section.

A 401(k) is one of the most common types of retirement accounts available to employees. Ask someone in the human resources department if you aren’t sure whether your company offers a 401(k).

What to ask your boss about your 401(k) plan

So you’ve ascertained that your company does, in fact, offer a 401(k). That’s great news; however, not all 401(k)s are created equal. Here are a few questions to ask HR or your boss about your new 401(k).

When will I be eligible to contribute?

Even if your company has a 401(k), you might not be able to contribute immediately. There’s often a probationary period (about three months, on average) to ensure you’ll be a fit for the position before you’re allowed to start making deferrals.

Compound interest works its magic only when it’s given the benefit of time, which means you’ll want to start investing as quickly as possible.

Does your plan feature automatic enrollment?

Some companies automatically enroll their employees in their 401(k) plan, taking deferrals out of your wages unless you specifically instruct them not to. Your employer is required by law to give you the option to forgo participation or to change the amount of your paycheck that will be withheld.

Saving for retirement is almost always a sound financial decision, but if you’re paying off debt or dealing with some other financial matter, you may not be ready to make large deferrals right away. On the other end of the spectrum, you may want to contribute more to your 401(k) than the automatic enrollment stipulates. Either way, knowing how your plan works ahead of time will help you make informed, intentional decisions about your investments.

Do you offer a match?

As we mentioned above, one of the best parts of a 401(k) is its sky-high contribution limits. For the 2021 tax year, you can defer up to $19,500 of your wages, but the total contribution cap is a whopping $58,000 or 100% of your compensation, whichever is lower. So how does that difference get made up?

Your employer also can contribute to your 401(k) account, which is most commonly done through a percentage match. For example, your company may opt to match your elective contributions (the ones coming out of your paycheck) up to 4% of your salary. That means that for every dollar you defer up to that 4% mark, you’ll get another dollar added to the account by your employer.

Although employers also can help you max out your 401(k) through profit-sharing contributions or bonuses, a match is one of the best ways to ensure you’re getting the most out of your retirement plan.

Is there a vesting period?

So now that you know your company matches 401(k) contributions, the account is yours to keep, right? Not so fast — you’ll need to make sure you know when you’ll be vested.

“Vesting” means obtaining total ownership of your retirement plan, and, depending on your company’s policies, it may take several months, or even years, to get there.

For instance, you may be able to immediately make matched contributions, but you won’t be fully vested until you’ve spent six months with the company. If you leave the company (or are let go) before that six-month period is up, any employer contributions and capital gains will be forfeited. (You will, however, always own the money you contribute to the account.)

Companies may offer full vesting after a certain amount of time or vest employees gradually over an extended period. For example, you might achieve 20% vesting after two years of service, 40% after three and 100% after six. On the other hand, some companies offer full vesting immediately upon hire, so it’s worth inquiring about the vesting schedule of your plan.

Can I make Roth contributions?

You’ve probably heard of a Roth IRA — a retirement account that allows you to make taxable contributions today so you can take tax-free distributions later.

But did you know there’s also such thing as a Roth 401(k)?

If your company offers a Roth 401(k), it is possible to make contributions — and it’s a lot more common than you might think, according to Malik S. Lee, certified financial planner and founder of Felton & Peel Wealth Management. “Most employers’ plans have Roth 401(k)s, but a lot of people don’t know to ask for it or to look for it,” he said, calling the Roth 401(k) “a “hidden gem.”

As nice as it is to get a tax break today, tax-free retirement income is tempting, especially if you’re planning to reach a higher tax bracket by the time you get there. (Here are more details on the differences between Roth and traditional 401(k) plans.)

What’s the annual fee?

Whether it’s a third-party custodian or someone in-house, someone has to manage your 401(k) — and that’s not free. You must pay an annual administration fee simply to participate.

Learning exactly how much that annual fee will eat away at your nest egg is important. It may be expressed as a percentage, or an “expense ratio,” such as 1% of your assets under management. That 1% isn’t too bad when you have $30,000 or less invested, but when that number inches closer to a million dollars later on, you’ll feel its impact.

How much control do I have over my portfolio?

Because your 401(k) is set up by your employer, you may not have as much control over it as you would with a personal brokerage account.

According to FINRA, the average 401(k) offers between eight and 12 alternatives (or investing options), which you may or may not be able to access through a digital portal.

You may be limited not only in your investment choices but also in how often you can reallocate your assets. You might be able to change your investments as often as you want or as seldom as once a quarter, which is why it’s so important to seek clarification before you enroll.

Should I contribute to a 401(k) if I’m a foreign national?

If you are a foreign national investing in a 401(k) depends on your individual situation. You are still eligible to receive the lucrative tax benefits of 401(k) as US resident. Most financial planners think the pros outweigh the cons, but if you are certain you will leave the US in short amount of time it may not be the best investment option.

How to set up your 401(k)

When it comes to the actual setup process, you’ll need to follow the instructions given to you by HR or your employer. If you have already had a 401(k) at a previous employer and are having a hard time locating it, try reaching out to your old employer or the National Registry of Unclaimed Retirement Benefits. In most cases, you’ll access an online interface, where you’ll be asked a variety of personal questions and questions about your investments. Here are a few you’ll probably encounter.

Which type of contributions will you make: Roth or traditional?

As we discussed above, you may have the option to make Roth 401(k) contributions. However, it’s important to note that if there’s an employer match, those funds will be deposited into a traditional account — which means you’ll still need to pay taxes on them when it’s time to take distributions.

What percentage of your income will you defer?

It’s always a good idea to sock away at least some of your income for retirement. The exact amount you should defer will vary depending on your personal financial landscape and goals.

If your employer offers a match, it’s wise to contribute at least up to that percentage unless you’re dealing with extensive debt or other mitigating financial circumstances.

Finally, be aware of the maximum contribution limit — which is $19,500 in elective deferrals for 2021 (with an additional $6,500 in “catch-up contributions” for those age 50 and over). Taking employer contributions into account, the limit is $58,000 per year. If you contribute more than the limit, the deferrals will count toward your taxable income — and be taxed upon withdrawal.

How will you allocate your assets?

Whether you have only a few mutual funds to choose from or an entire brokerage window, allocating your assets well is the key to weathering inevitable market fluctuations and coming out with the nest egg you need.

While we can’t offer specific investment advice, here’s how to research your investment options:

• Look for low fees. You’re already paying an annual fee for your 401(k) account, so you want to keep other expenses, such as trading fees and commissions, as low as possible. Choosing investments with low expense ratios will keep more of your money in the market.
• Research historical performance. Although nobody can predict the future, looking at how an asset has performed historically can be a good indicator of how it will continue to behave in the future.
• You’ve heard it before, but we’ll say it again: diversify, diversify, diversify. The old adage about having all your eggs in one basket is true, so choose as many different types of assets as possible. You can buy different types of securities (such as stocks and bonds) and diversify their types (such as foreign or domestic companies, technology, and commodities). Doing so will help you avoid a catastrophic loss in the case of a crash or recession.

Your 401(k) is set up — now what?

Your contributions will automatically be deducted from each paycheck, so you won’t have to worry about making them manually. You’ll want to check your first pay stub to ensure the right amount is being deducted.

Remember: A retirement plan is all about the long haul, so don’t panic if things go south for a while or if you aren’t currently happy with your specific investments. You can always reallocate as your plan allows.