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9 questions about 401(k)s you were too embarrassed to ask

Know why they're so happy? They saved early and then allocated their assets well.
Know why they're so happy? They saved early and then allocated their assets well.
Shutterstock

You're paying down your debt, not buying $11 salads for lunch every day, and trying to manage your finances in a responsible fashion. But you don't understand your 401(k) — how much to put into it, how to invest, or why it's even there. Don't worry; we have you covered. We're here to answer the most pressing questions about that retirement account you may not be using — but probably should be.

1) What is a 401(k)?

A 401(k) is one of the best and most accessible ways for people who get a regular paycheck to save for retirement. A 401(k) takes money from your paycheck and automatically deposits it into an account of your choosing, where it will usually be invested in stocks and bonds that should grow in value over the long run.

As we'll discuss below, 401(k)s offer two key advantages. First, the money is sheltered from taxes, which means that more of your investment returns go to you rather than Uncle Sam. Second, many employers match employee contributions, giving you an extra financial incentive to participate.

But there's a catch: you can only invest in a 401(k) if you work for an employer that offers one. According to the Labor Department, 55 percent of US workers had access to defined-contribution plans (a category that includes 401(k)s) as of March 2013, and of those, 69 percent participated.

The 401(k) program is designed for private, for-profit employers. Other types of employers offer similar plans. For example, non-profit organizations can offer a similar plan known as a 403(b)s. While this article focuses on 401(k)s, most of the principles laid out here apply as well to other types of employer-sponsored retirement programs. such as 403(b)s. (In addition, this article focuses on traditional 401(k)s, which take money out of your paycheck pre-tax; Roth 401(k)s, which are far more rarely used, take the money out post-tax.)

2) Why should I put my money in a 401(k)?

If you have access to a 401(k) — and particularly if you don't have another vehicle for retirement savings — putting your money into a 401(k) is a great idea for two broad reasons.

One is taxes. One big draw of a 401(k) is that it allows you to start saving your money without paying taxes on it. Yes, you'll be taxed when you pull the money out, but in the meantime your earnings won't be taxed.

This makes a 401(k) a better approach than putting your savings into a normal, taxable investment account. These accounts do give you the flexibility to take the money out whenever you want. But because you have to pay taxes on the original savings and also on any investment earnings, your total tax bill will be higher, and you'll wind up with less money when it comes time to retire.

401(k) plans also make it easier to save. Because they automatically invest money from your paycheck, they allow you to save up for retirement without really thinking about it. Since a portion of your paycheck never touches your bank account to begin with, there's not the temptation to spend it. A 401(k) plan works on autopilot: you're saving constantly, without ever having to think about it.

This is important because compounding interest can dramatically increase the value of your savings. Each year, you earn money not only on your original savings, but on money you earned in previous years. The result: if you keep your money invested for multiple decades, you can wind up with vastly more money than your original investment. The chart below illustrates this nicely — saving early and often is the key to a comfortable retirement.

401k returns

Source: JPMorgan Chase

Your employer might even help you out by matching your 401(k) contributions. At investment management company Vanguard, 91 percent of plans offer some sort of employer contribution, and most of those offer 50 percent of what you put in, up to 6 percent of your pay.

Imagine if your boss was holding out a check to you and you refused to take it. That's what you're doing if you don't take advantage of a 401(k) match.

3) How do I know where to invest?

There are a few classes of investments where you can put your money. In order of most to least risky, they are equities (or stocks), bonds, and cash equivalents.

Most people invest in some mix of those three. But the key thing to remember here (or with any investment) is that, in the long run, riskier assets tend to produce higher returns. Stocks generally produce higher returns than bonds, which produce higher returns that putting your money into a savings account.

This means that the younger you are, the more money you should put into the stock market. If the stock market crashes when you're in your 30s, you'll have three decades to recover. Meanwhile, older workers would be smarter to put their money in bonds, a less volatile type of investment.

But it's never a good idea to put all of your savings into one type of asset. When stocks go up, bonds tend to go down, so having a bit of both can do a lot to stabilize your balance.

Professionals recommend that investors under the age of 40 should put 75 to 90 percent of their savings into the stock market. By the time you reach your 60s, you should have the majority of your savings in bonds — though it's still a good idea to have around 40 percent of your savings in the stock market.

4) Didn't a lot of people lose their 401(k)s in the recession? This all sounds risky.

It is true that 401(k) investments are risky. If the stock market crashes, as it did in 2008 and 2009, you could stand to lose a major chunk of your account balance. According to one report, people with more than $200,000 in their accounts lost an average of 25 percent of their 401(k) holdings from January 2008 to January 2009, and some people lost much more than that.

This is partly about thinking long-term. It was painful for people to lose big chunks of their 401(k)s, but the crash was only a catastrophe for people near retirement who were over-invested in stocks. For younger workers, who still had decades of work ahead of them, the crash wasn't a big deal.

You can think about this by looking at the S&P 500 a popular index of stock prices. The index did plummet in 2008 and early 2009, but it had bounced back to its pre-crash highs in 2013. The same point applied in previous stock market crashes. If you hold on, you can almost always ride them out.

For older workers, the key concept is diversification. Older workers who had a majority of their savings in bonds in 2008 (as we recommend above) did OK during the recent crisis, since bonds gained value at the same time stocks were crashing.

The key for both groups is to avoid panic-selling. A lot of people have an instinct to sell right after the market crash, but that's a big mistake, since huge market declines are often followed by big gains. Younger workers should hold on to their stock investments no matter which way the market moves. And workers who need to cash in their stocks to cover retirement expenses should do so gradually.

5) How do I choose the best funds to invest in?

A common mistake in choosing mutual funds is to focus too much on a fund's past investment returns. Returns are unpredictable, and the fact that a fund did well over the last 1, 5, or 10 years doesn't mean it will do better than average in the future.

But one thing you can be sure of is that every dollar your mutual fund company spends managing your money is a dollar you won't have at retirement. So your primary criteria in choosing a mutual fund should be to find one with the lowest fees and expenses. A difference in fees of just a few tenths of a percentage point can cost you tens of thousands of dollars over the years.

A good option is an index fund, which tracks a broader market index. For example, most mutual fund companies offer funds that track the S&P 500 — if that goes up by 4 percent, so do your investments (minus fees and expenses). Index funds often have low expenses, which has allowed them to outperform funds where stocks are handpicked by an investment professional.

There are also target-date funds, in which you essentially say, "Here's when I think I'll retire. Please shift my money around accordingly." The benefit here is being able to put the money in one place and let someone else worry about getting the right mix of stocks and bonds. But most target-date funds have high fees, so be sure to check a fund's expense ratio before you trust it with your money.

Morningstar is a great place to find out what kind of assets a fund invests in and to look up its expense ratio.

OK, so how to figure out if a fund's costs are too high? When you are researching funds, look for something called an "expense ratio" — the cost of an investment as a percentage of its assets. The best index funds (from Vanguard and Fidelity) have expense ratios of 0.05 to 0.14 percent. Vanguard also offers target retirement funds with expense ratios under 0.20 percent.

Unfortunately, these low-cost funds are not available to every mutual fund customer. Which funds are available depends on which mutual fund company your employer chooses, and some companies only offer funds with high fees.

Some 401(k) plans also have plan administration fees. These tend to be higher for tiny companies than huge corporations, says Joe Valletta, a certified financial advisor and co-author of the 401(k) Averages Book, an annual publication from 401(k) Source, a 401(k) information organization. "The higher the total assets and the higher the average account balance, typically the better prices you'll get."

If your employer picked a company that only offers expensive plans, you might want to consider saving your money outside the 401(k) system. You should still contribute enough to earn your employer's match, since that's free money. But you might want to put the rest of your savings into an individual retirement account (IRA), a 401(k)-like savings vehicle that can be opened directly by individual investors.

401k piggy bank

That's not how it works. (Shutterstock)

6) Why do companies offer 401(k)s?

One big reason is that it's a way to help employees save for retirement without an employer having to pony up a full pension.

"The advent of 401(k)s…came about in lieu of company-funded pension plans. An employer making a modest matching contribution to an employee's 401(k) is still far more economical for a company than providing a pension for the employee," says Greg McBride, senior financial analyst at Bankrate.com.

The 401(k) was born in the late 1970s, when Congress passed section 401(k) of the tax code (hence the name). That allowed for employees to set aside pre-tax money for retirement. But the idea of incentivizing that saving by having employers provide matching funds helped 401(k) plans gather steam, because firms could now provide retirement plans, get tax breaks, and not spend that much money. By the early 1980s, employers were increasingly adopting the plans and scrapping pensions.

Today, 401(k)s and similar plans like 403(b)s are standard features of compensation packages.

You might hear the 401(k) defined as a "defined contribution" plan. That means an employee sets aside a certain share of her income to the account (though employers often contribute, too). The opposite is a "defined benefit" plan, in which the employer pays retirees a set amount once they leave the workforce.

While those sorts of plans offer a steady stream of income to retirees (and require no investment knowhow), the share of employers offering defined-benefit plans has steadily declined in recent years, as the below chart shows. That means that, though 401(k)s aren't perfect, they're one of your better options right now.

Pensions vs 401k

(Center for Retirement Research)

7) How much should I save?

First off, check out Vox's retirement calculator and while you're there, read Timothy Lee's four rules for retirement.

But the short answer is: save a lot. Save what you can, and then a little more.

It's hard to get specific — so many variables that play into this: how much you earn, how much money you think you'll make when you retire, how early you want to retire, how early you started saving, how lavish a retirement you want to have, whether a spouse or partner is saving with you, what kind of investments you have elsewhere...

There are lots of calculators that will give you different numbers, and it's important to remember that they're all imprecise instruments that also require a bit of guesswork on your part: how much will your salary increase? What sort of a rate of return will your investments give you?

Often, experts and investment management companies will express the total amount you should save as a multiple of your final salary — Fidelity says to save eight times your final salary, and T. Rowe Price has said 12 times. The median income for a male age 55 to 64 in 2013 was nearly $42,000. If that were your final salary, you'd need a few hundred thousand, at least — $336,000 by Fidelity's standard and $504,000 by T. Rowe Price's.

And what this means is if you think you'll earn $83,000 or more annually by the time you retire, you could need to save $1,000,000.

8) Should I take money out of my 401(k) before I retire?

Usually, it's a bad idea.

If you do try to take the money out of it before age 59.5, you will by law pay huge penalties on it. The IRS will impose taxes on what you take out, plus a 10 percent early distribution penalty. Also, taking money out now means it can't continue to earn money for you down the road.

This means even if you have a really good plan for what you want to do with that money — buy a house, pay off a student loan — you're missing out on a lot of benefits that money would bring you (and handing a hefty chunk of it over to Uncle Sam). That said, if you have debt with a super-high interest rate, then it might make sense to withdraw money.

There are exceptions to the age 59.5 rule, known as hardship withdrawals. The IRS says if a person has an "immediate and heavy financial need," that person can qualify to take money out penalty-free. Cases that the IRS says meet this criteria can include medical expenses, payments to avoid foreclosure, and burial or funeral expenses but not all of these things will clear the bar of "immediate and heavy" need at all times.

Retirement

Your retirement could also look like a beautiful beachy Cialis commercial. Just save big! (Shutterstock)

9) Yeah, but what if I have debt? Shouldn't I just pay that off first?

Often, the best course is to both save for retirement while paying off debt. You of course want to keep up on your minimum payments on your debts, but you also need to save for retirement starting as early as possible. One way to think about how much to save is to consider the amount that your employer will match a sort of minimum — you want to take advantage of as much of your employer match as you can, not to mention take advantage of compounding returns while you can.

But of course, it makes sense to pay off your high-interest debt as fast as you can as well. If you have a high-interest credit card, you may want to prioritize that, aggressively paying that down. Meanwhile, if your student loans, for example, have low interest rates, and there's the potential to get big returns on your 401(k), it makes sense to prioritize retirement...while still making those loan payments, of course.

Think of it in terms of interest rates versus rates of return. If your 401(k) is bringing in a 5 percent rate of return, it would make sense to prioritize debt with a much higher interest rate — a credit card or a private student loan with interest of 8 percent or more, for example. And if you have a federal student loan with, say, a 3 to 5 percent interest rate, it would make more sense to focus more on your retirement

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