Financial Planning For Young Adults: Saving For Retirement With Your First 401(k)

Are you starting your career or a new job and want to know if you should opt in to the company 401(k) plan? Or are you new to saving in a 401(k) and want to learn about some of the basic features? 

If you just started a new job or are evaluating multiple offers, you shouldn’t focus solely on the salary. You should also consider everything a company has to offer—including whether the benefits package allows you to participate in an employer-sponsored retirement plan, such as a 401(k).

What is a 401(k)?

A 401(k) is an employer-sponsored, tax-advantaged retirement plan and is one of the smartest and best ways to save for retirement.

The 401(k) takes its name from the subsection of the Internal Revenue Code that makes it possible for employees to defer a portion of their compensation and pay taxes later.

How a 401(k) plan works

A 401(k) plan is a retirement plan that is established by an employer (the plan sponsor) for the benefit of its employees.

With a traditional 401(k) plan, employee contributions are made with pretax dollars, which can boost your savings power and lower your taxable income. However, you’ll eventually pay taxes on both your contributions and any investment growth when you begin taking withdrawals from the account.

Consider a Roth 401(k)

Roth 401(k) plans are an increasingly popular option. With a Roth 401(k), contributions are made with after-tax dollars, and withdrawals in retirement are tax-free. Not all companies offer a Roth option, but if yours does and you think your tax bracket will be higher when you retire, a Roth account may make sense for you.

Enrollment eligibility

Rules for when you can enroll vary by company. Some plan sponsors will allow you to sign up for the 401(k) plan on your first day of employment. Others will make you wait anywhere from a few months to a year, or you may only be allowed to opt in during an open enrollment period.

How much should you contribute?

While the best advice is to contribute as much as you can as early as you can, maxing out your retirement contributions on a starting salary may not be practical or possible.

Bills such as student loans, food, rent and utilities can quickly exhaust a paycheck, making it difficult for young people to save. Depending on your situation, it may be more realistic to save what you can today and plan to increase the amount you contribute over time.

Get paid to save with an employer match

Some employers will match employee contributions up to a certain amount. Contributing enough to get the full employer match should be a top priority, because the 401(k) employer match essentially pays you to save. For example, if you earn $50,000 annually, a 50% match on contributions (or 50 cents on every dollar you contribute) up to 6% of your salary can boost your retirement savings by $1,500 every year. 

While any contributions you make to a 401(k) will always belong to you, a lot of companies will have what is called a vesting period for matched contributions, which means you may be required to remain with the company for a number of years before the matching contribution becomes yours outright. Vesting periods vary by company. Some plans have a vesting schedule that spans several years of service, while others have a vesting cliff that requires an employee to stay with the company for a set number of years before fully vesting.

Investing your 401(k)

Generally, 401(k)s are self-directed, which means it is up to you to decide how much to contribute and how to invest. Each 401(k) plan will have a select number of investments to choose from. Depending on the plan, the universe of potential investments could include thousands of mutual funds, or your choices could be limited to a handful of investments.

When selecting investments for your 401(k), you’ll want to make sure that you have diversified exposure to a combination of stocks, bonds and cash to match your time horizon and risk tolerance.

What if you change jobs?

When you change jobs, you essentially have four choices:

1.     You can cash out your 401(k) account. However, this isn’t recommended, because you’ll be charged a 10% early withdrawal penalty (unless you are age 59½ or older) and have to pay taxes on the amount of your withdrawal.  

2.     You can leave your 401(k) account with your former employer’s plan. But if you end up having multiple jobs over the course of a career, which is quite common, it can be difficult to manage and keep track of multiple accounts.

3.     You can roll over your old 401(k) account to your new employer’s plan. Consolidated retirement accounts will be easier to manage, but as a rule of thumb, employer-sponsored retirement plans tend to be much more restrictive and have higher expenses than a rollover individual retirement account (IRA).

4.     You can roll over your account to an IRA. This is often the best choice for people because not only can you choose your own custodian, but you’ll also likely have more flexible investment options.

Although 401(k) plans are fairly common, not all companies offer an employer-sponsored retirement plan. Likewise, not all features will be available with all 401(k) plans. If the company you work for does not have a company retirement plan, you can still save for retirement with a traditional IRA or Roth IRA.

CIBC Private Wealth’s Wealth Your Way podcast series is an educational offering for clients and their children, and demonstrates our commitment to developing the rising generation. Listen to the podcast on savings options and retirement plans here. There, you will also find other informative podcasts that are designed to help rising professionals steer through their personal financial journeys.