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If you recently landed your first full-time job, congratulations are in order. However, there’s quite a bit to learn when you get your first “real” job, especially when it comes to the benefits package your employer offers.
One of the most important, and least understood, types of employee benefits is retirement plans. And it isn’t just new employees — many people who have been in the working world for decades are completely confused when they have to fill out paperwork to enroll in a 401(k) or similar retirement plan. With that in mind, here are three of the biggest decisions you’ll need to make when enrolling in a retirement plan, and what to keep in mind to help make the best choices for you.
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Traditional or Roth?
Nearly 90% of 401(k) plans offer participants a “Roth” option, but fewer than 30% of workers make Roth 401(k) contributions. So, it’s important to know what this means and evaluate if it’s right for you.
In a nutshell, you have two ways to save for retirement in your employer’s plan (assuming there is a Roth option). The traditional way of saving is also known as tax-deferred retirement contributions. Essentially, the money you contribute from your paycheck is excluded from your taxable income, so if you are paid $75,000 in 2023 and contribute $5,000 to your 401(k), it will bring your taxable income down to $70,000. However, when you retire, any withdrawals from the account will be considered taxable income.
On the other hand, Roth contributions don’t get you a tax break right away. Instead, any eventual Roth 401(k) withdrawals will be completely tax free.
In short, do you want your tax savings now or later? Generally speaking, if you’re in a lower tax bracket (like many are when they start their career), Roth 401(k) contributions can be beneficial by allowing you to pay your current tax rate on your money. If you’re a higher earner, the immediate tax savings could be the way to go.
How much should you save?
Financial planners have different rules of thumb when it comes to how much is enough to save for retirement, but one common guideline is that workers should aim to set aside 10% of their salary in retirement accounts like a 401(k). This doesn’t include any matching contributions your employer makes on your behalf.
Most retirement plans have an auto-enrollment feature and a default contribution rate that is not enough. To be fair, the default contribution rates of workplace retirement plans have increased significantly over the past few years — 6% is now the most common, while 3% was the standard for a long time. However, even a 6% savings rate may not be sufficient to produce financial freedom in retirement.
How should you invest?
Your employer’s 401(k) or other retirement plan will offer a mix of investment options, usually in the form of mutual funds. These vary from plan to plan, but there are a couple of things to keep in mind.
First, most plans offer target-date retirement funds designed to provide an all-in-one investment option that starts out aggressive but becomes more conservative as you approach retirement. You’ll see these labeled as something like “XYZ Target Retirement Fund 2050.”
Second, plans generally offer a default asset allocation and/or access to retirement planners who can guide you through setting up an investment plan. Unless you’re familiar with the basics of mutual fund investing, you should absolutely take advantage.
There are many right ways to invest for retirement
One key takeaway is that there isn’t one perfect answer, and a lot of retirement savings is simply a matter of preference. For example, regardless of your income level, choosing either traditional or Roth 401(k) contributions isn’t a bad move. So, while the goal should be to optimize your retirement plan to best meet your goals, the most important thing is to save the right amount and stay invested over the years.
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