What is a 401(k)? How to maximize your savings for the future

Alex Thomas Sadler

When you enter the real world, you start to hear about all sorts of things that immediately make you feel extremely under-prepared for life after college.

The thought goes something like this: “um, $#*!, am I supposed to know what that is??” — and it’s a pretty common one. And what’s even more frustrating is not wanting to ask about something “you should already know about,” and then as more time goes by, you think, “well I definitely can’t ask now …”

We’ve all been there, and very often, we all still face that scenario in some way shape or form. So if you’ve ever been in that situation, you can take comfort in the fact that everyone else has too!

When did anyone ever teach you about retirement savings in school? It’s probably safe to assume that the answer is never.

You probably hear that it’s important to save and invest for your retirement — OK, what does that even mean?

Let’s start from the very beginning. This guide walks you through the basics of retirement savings, including why you need to save for the future — especially when you’re young — and how to get started.

Making smart decisions with your money doesn’t mean memorizing financial definitions — it’s just about having a little Common Cents!

Why you need to start saving for retirement

When you’re young, saving for retirement may not be a priority, especially if you aren’t making a ton of money and retirement seems like a lifetime away.

People put off saving for retirement for a variety of reasons — I can always save later, that’s so far away, I don’t make enough money — the list goes on.

But whatever the excuse is, chances are it’s not good enough.

Here’s why: the sooner you start saving for the future, the more time your money has to grow and the richer you’ll be down the road. Plus, the earlier you start, the less you have to save each month.

Compound interest

The money you save now is worth a lot more than the money you save later.

One of the most important things to understand about money is that a dollar today is worth more than a dollar tomorrow. The time value of money assumes a dollar now is worth more than a dollar in the future, because of variables such as interest rates and inflation.

Compound interest is an extremely powerful force that allows you to earn exponentially larger gains on your money over time — which basically means if you put money in a retirement account today, it will grow into a much bigger amount than if you waited and put the money in five years from now.

If you have a $100 bill and do nothing with it, the value of that piece of paper will decline as time goes by. So even one year from now, that $100 bill would buy you less than it could today.

But if you put that $100 into a retirement account, it will start to earn interest, and that $100 will grow into a much bigger sum of money over time.

Here’s an example: if a 16-year-old saves $2,000 annually for six years, putting the money into a Roth IRA, a type of retirement savings account, and stops at age 21, he or she would have $1 million by age 65.

This assumes a 9.4 percent average gain annually, which has been the average return on the stock market since 1926.

So the earlier you start putting money away in a retirement account, the more time it has to earn you a lot more money. If you keep telling yourself you can always save later, and even if you do contribute a lot more later than you would now, that money still wouldn’t have the time to grow like it would if you saved now.

Saving money early — not even often, just early — will still ultimately lead you to bigger wealth at the time of retirement. Imagine if that 16-year-old continued to save way beyond just six years — that sum of money would at least double.

The easiest way to start saving for retirement

There are several options for you to save for the future, but the easiest way to start saving for retirement is with your 401(k) plan at work.

A little background: Many people have heard about a 401(k) but aren’t quite sure what it is and how it works, which is understandable since the name isn’t very intuitive.

The name 401(k) comes from the section of the tax code that describes this type of account. Starting in the 1980s, 401(k)s became an increasingly popular way for employers to provide workers with a retirement savings plan in place of a traditional pension plan (which guarantees an employee automatic payments in retirement based on how much money they made and how long they works). Basically pensions became too expensive, so 401(k)s became the primary way people now accumulate money for the future.

That’s just some info for context and your next round of trivia. Now let’s get into what you need to know to get started and how to maximize your savings with a 401(k)!

What is a 401(k)?

Let’s you just started your first job, or maybe you’ve been in the same job for a while and decide you’re ready to start saving for retirement. Your employer offers a 401(k) but you don’t know how to get started or even what a 401(k) is.

Here’s a 401(k) in nutshell: a 401(k) is a retirement savings account offered by your employer, so the company you work for.

It lets you save and invest a piece of your paycheck before taxes are taken out, and then you don’t pay any taxes on the money in a 401(k) account until you withdraw from it — ideally, when you’re retired.

How does it work?

When you opt into the plan, you decide what percentage of your annual income you want to contribute, and then the money is automatically taken out of each paycheck, based on that percentage, and sent directly into your 401(k) account.

So where does that money actually go? Companies usually hire an investment firm to oversee their employees’ 401(k) accounts and investments. Let’s say your employer uses Fidelity — that would mean your 401(k) account and the money invested in it are managed by Fidelity.

Clark.com: How much you need to save every month to be a millionaire by the age of 65.

What decisions do you have to actually make?

When you started your job, you were probably handed a giant packet of information about your company’s 401(k) plan – filled with a bunch of explanations that only a Wall Street expert could actually understand. Then you’re expected to interpret what’s basically written in another language in order to make decisions that will affect how much money you have in the future.

Forget about all that. Remember using Cliff’s Notes in high school or college? (Don’t lie, everyone did it at some point.) Well, here’s your Cliff’s Notes version of what exactly you need to do with your 401(K)!

1. Choose the percentage of your income you want to contribute

If your employer offers a match on your 401(k) contributions, then ideally, you want to put in at least enough to get the match. For example, many companies will match 50 cents on the dollar up to 6%.

So let’s say you’re making $30,000 and you put 6% of your annual salary into your 401(k), which is $1,800, then your company will put in 3%, so another $900 — totaling $2,700 a year.

Matching plans vary, so make sure to check with your company to find out exactly how much they will match.

Contributing at least enough to get the match is the best way to maximize for your 401(k) savings, because the money your company puts in is basically free money toward your retirement. So the more you contribute up to that 6% (or whatever your company’s match limit is), the more money they will put in, too.

Using the example from above, if you’re making $30,000 and contributing 6% of your salary to your 401(k) — that would mean about $70 would be automatically taken out of each paycheck, assuming you get paid every other week.

When you’re just starting out and can’t quite afford to contribute that much, start with just 1 percent — you won’t even notice it missing. Then every six months, bump that up by another 1 percent, and after just a couple of years, you’ll get pretty close that 6%!

2. Choose how the money in your 401(k) is invested

The money you put in a 401(k) can be invested in a variety of ways.

But if you aren’t a seasoned investor, your best choice is a target retirement fund.

Here’s how it works: You select the year closest to when you want to retire and put all of your money into that fund. For a 30-year-old, it would be a 2050 target retirement fund.

The money is then invested into a variety of things, like big company stocks, little company stocks, international stocks and a bunch of different types of bonds.

Once you set the fund you want your money to go into, that’s it. The company that handles your account manages how your money is invested in order to minimize your risk and maximize the earnings on your savings.

When you’re younger, your investments can be riskier, since they have more time to bounce back from losses in the stock market. As you get older, you don’t want to risk losing all the money you’ve accumulated, so the investment choices in your fund will steadily get more conservative.

So all you have to do is put the money in and the rest is done for you.

3. Traditional 401(k) or Roth 401(k)?

Some companies give you the option of choosing a traditional 401(k) or a Roth 401(k).

If you have this option, you first need to understand what a Roth is. A Roth IRA is a retirement account in which you set aside after-tax income.

With a traditional 401(k), you put in money that hasn’t been taxed yet and you don’t pay any taxes on it until you withdraw money in retirement.

With a Roth, you put in money that’s already been taxed, so you don’t pay any taxes on the earnings or any of the money you withdraw in retirement. So the money grows tax-free and is spent tax-free in retirement.

The tax advantages of a Roth are about as good as they get when it comes to retirement savings.

The reason a 401(k) is your best option to start saving for retirement is because it’s automatic and requires pretty much no effort on your part. A Roth IRA requires you to open the account and consistently put money in there. So for people who are just starting out, they may intend to put money in a Roth, but then they don’t end up saving as much as they had planned.

That’s what makes a Roth 401(k) a great option!

If you have the option of a Roth 401(k), you can get the best of both – automatic contributions from your paycheck so you aren’t tempted to spend the money and the tax benefits that come with a Roth.

So you don’t have to worry about disciplining yourself to save the money, since your employer will automatically do it for you.

What to do with extra savings

Emergency savings

If you don’t have emergency savings, that should be a priority.

So while you’re contributing to your 401(k), you should also be setting aside money for an emergency. Life is full of surprises, and if you aren’t prepared for them, you could end up doing some serious long-term damage to your financial life.
The best way to save for unexpected financial shocks is to have two separate emergency funds: a rainy day fund and an emergency fund.

  • A rainy day fund is money you might dip into every once in a while to cover an unexpected expense, like a medical bill.
  • An emergency fund is a bigger, longer-term savings fund. This money should be able to cover at least three to six months worth of living expenses in case you can’t work for a period of time, for whatever reason.
    Keep the money in separate savings accounts so you can easily access it if you need to, and by keeping them separate you won’t be tempted to dip into the cash for something that’s not an emergency.

Extra retirement savings

Once you’re saving enough in your 401(k) to get the employer match, any extra money you have to save for retirement is better off in another type of retirement account.

So rather than contributing more to your 401(k), a better option is to open a Roth IRA in addition to your 401(k) as a way to put more money away for the future in a tax-friendly account.

We went over the basics of a Roth above, but here’s a more detailed overview of how it works.

  • A Roth is a modified individual retirement account in which you can set aside after-tax income. Earnings on the account are tax-free, and tax-free withdrawals may be made after age 59 1/2. You can contribute up to $5,500 per year into a Roth; for people age 50 and older, the maximum amount is $6,500 a year.
  • You can set up a Roth account yourself — with as little as $100! Here are some options by dollar amount for opening a Roth.
    Don’t forget about your other goals …

Depending on your situation and your individual goals, it’s important to prioritize where your extra money is going.

If you want to make a big purchase in the next few years, like a car or a house — you need to be preparing for those goals now.

Check out our Savings Guide for more details on saving for various goals, including how much to save, how to get started and where to put all that money.