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How to Set Up Your 401(k)

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

binder that says retirement safety plan, glasses, calculator, pen, coffee

Did you recently start a new gig with a swank set of benefits, including a 401(k)? Congratulations! You’ve just gained access to one of the most powerful retirement tools available.

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 2020, you can defer up to $19,500 of your wages, but the total contribution cap is a whopping $57,000 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. (In other words, it’s free money!)

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.

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. 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 2020 (with an additional $6,500 in “catch-up contributions” for those age 50 and over). Taking employer contributions into account, the limit is $57,000 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.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Jamie Cattanach
Jamie Cattanach |

Jamie Cattanach is a writer at MagnifyMoney. You can email Jamie here

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What Is a Solo 401(k)?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

pink piggybank stuffed with bills

Self-employment comes with many perks, but you may think access to a 401(k) plan isn’t one of them. Considering the 401(k) is one of the most powerful and accessible investment accounts available to the American public, not having one can be a pretty big loss.

Good news, entrepreneurs: You can have your freelance cake and eat it too! There is such a thing as a solo 401(k), also known as a personal 401(k), individual 401(k), self-employed 401(k), or — our personal favorites — a solo-k or uni-k. Since the solo 401(k) rules are similar to those that govern traditional 401(k)s, you won’t miss out on the high contribution caps that come with combined employee-employer contributions.

So how does this unique solo retirement plan work, exactly? Who’s eligible, and how much can you contribute overall? Read on to learn more about this Goldilocks investment account for self-employed savers.

Solo 401(k) basics

A solo 401(k) is an investment plan designed to help you save for retirement by “deferring” a portion of your income and allowing it to grow tax-free on the market. This boosts your savings goal in a couple of key ways.

Investing your hard-earned cash takes advantage of the power of compound interest, turning even a small investment into a cushy nest egg down the line. In the short term, you’ll benefit from a tax advantage because 401(k) contributions don’t count toward your total taxable income. The exception to that rule is a Roth solo 401(k), wherein your contributions will be taxed today but won’t be subject to tax when you withdraw them later.

Any self-employed individual or sole proprietor is eligible to open a solo 401(k), and a wide variety of traditional 401(k) custodians also offer solo-k options.

If you’re familiar with the basic workings of a regular 401(k), you already know a whole lot about the solo-k too. According to the IRS, “These plans have the same rules and requirements as any other 401(k) plan.”

However, there are a few key differences in the nitty-gritty details for solopreneurs to keep in mind. Let’s take a look!

How much can you contribute to a solo 401(k)?

Like regular 401(k)s, solo 401(k)s come with generous contribution caps, making them an appealing option for those looking to aggressively save for retirement. You’ll be able to contribute up to 100% of your earned income, capping out at $19,500 — or $26,000 if you account for the $6,500 “catch-up contribution” available to investors aged 50 or over.

The total contribution cap — including “nonelective contributions,” i.e., the freelancer’s equivalent of employer contributions in a regular 401(k) — is much higher.

Your specific contribution cap must be determined using a “special calculation” based on your “earned income,” which, according to the IRS, is defined as your “net earnings from self-employment after deducting both one-half of your self-employment tax and contributions for yourself.” You can make these calculations using the rate table or worksheets in Chapter 5 of IRS Publication 560, “Retirement Plans for Small Business,” or feed your personal financial data into a contribution calculator, like this one from Fidelity.

No matter how much you earn, the overall contribution limits for a solo 401(k) match those of any other 401(k) plan. For 2020, that cap is $57,000 — or $63,500 for those eligible to make catch-up contributions.

There is one big caveat, however, which can catapult your retirement savings to the next level: the spousal exemption.

If you’re married and your spouse earns income from your business, he or she also can contribute up to the $19,500 elective deferral limit — and you can put in up to another 25% of your compensation as a profit-sharing contribution. That means your total contribution limit could effectively double from $57,000 to $114,000.

Solo 401(k) withdrawal rules

Now that we’re clear about how much money you can put into your solo-k, let’s talk about the most important part: taking it out again.

As is the case with a regular 401(k) plan, there are strict rules governing when you can (and must) make withdrawals, and there are penalties in place for those who withdraw their assets early.

In order to avoid taxes and fees, you must wait until you reach the age of 59 and a half before taking distributions from your solo 401(k) plan. You also may be able to access the money with impunity if you can demonstrate “immediate and heavy financial need,” per IRS rules.

If you do take out early withdrawals without meeting one of the exceptional circumstances, the money will count toward your total taxable income for that year — and will be subject to an additional 10% tax as a penalty. Of course, you’ll also be missing out on the opportunity to allow your money to grow.

Like most retirement plans, the solo-k is subject to required minimum distributions. In general, you’ll need to make your first withdrawal by April 1 of the year following the year in which you turn 70 and a half.

Other retirement accounts to consider

If you’re working for yourself, there are a number of alternatives to the solo 401(k) when it comes to saving for retirement.

An individual retirement arrangement (IRA), is an investment account that allows any individual to save for retirement, regardless of their employment situation. IRAs come in both traditional and Roth varieties. They are easy to set up and available through a wide range of financial institutions.

IRAs provide many of the same tax benefits as 401(k) plans. For instance, traditional IRA contributions may be fully or partially tax-deductible, depending on your circumstances, and while contributions to a Roth IRA are taxed, they are then available for tax-free withdrawal upon retirement.

However, IRAs carry a much lower contribution cap than 401(k) plans — just $6,000 for 2020 (or $7,000 if you’re aged 50 or over).

Another popular option for self-employed individuals is the simplified employee pension (SEP) plan. In a SEP plan, contributions are made by the business only, which means you won’t get a tax break on your personal income. The contributions will, however, count as a business expense, and they are deductible up to 25% of employee compensation.

Although SEP plans carry higher contribution limits than IRAs, the “25% of compensation” clause may drive the limit lower than it would be for a solo-k plan, depending on your income. SEP plans also don’t allow catch-up contributions for savers close to the age of retirement, and there’s no Roth option available.

Whether you work for yourself or someone else, saving for retirement is the foundation of any solid financial roadmap. For those who choose to strike their own path, a solo 401(k) plan is an excellent option for paving the road to retirement.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Jamie Cattanach
Jamie Cattanach |

Jamie Cattanach is a writer at MagnifyMoney. You can email Jamie here

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7 Reasons to Consider Opening a Roth IRA

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

older couple talking with financial planner

An IRA, or individual retirement account, is one of the most accessible ways to invest in your future. These accounts carry special tax benefits and are available to the majority of savers, even if you’re not working for an employer that offers a 401(k) or another retirement account.

But as you’re preparing to open an IRA of your own, you’ll soon be faced with a decision: traditional or Roth? Although these two accounts have many things in common, they have some important differences too.

A traditional IRA allows you to make tax-deductible contributions, easing your tax burden today and helping you grow your funds for the future. It carries a $6,000 contribution limit (2020), but you can open the account no matter how much income you earn.

On the other hand, with a Roth IRA, your contributions are taxable — but they’re allowed to grow tax-free thereafter. Although Roth IRAs have the same $6,000 contribution limit traditional IRAs have, they are subject to income limits. For example, if you’re a single filer, you’re eligible to contribute only if you earn less than $139,000. If you’re married filing jointly, you’re eligible to contribute only if you earn less than $206,000.

Roth IRA benefits: what makes losing out on the deduction worth it?

Although the chance to earn a tax credit today may seem like a no-brainer, there are lots of reasons Roths are advantageous in the long run. Here’s why you should consider selecting the Roth option when opening your IRA.

1. Roth IRAs are flexible

Since you’ve already paid taxes on your Roth contributions, you’re free to withdraw them from the account whenever you want with no further taxes or penalties. However, it’s important to note that you can’t withdraw any gains you’ve made through appreciation.

That means you can use your Roth IRA as a long-term savings account both for retirement and for shorter-term financial goals, such as buying a house or going to college. In fact, the Roth is even more accommodating in those instances because first-time homebuyers and people funding higher education can take distributions, including capital gains, without paying the additional 10% penalty.

2. Roth IRA tax benefits ease the transition to retirement

Although you may earn Social Security benefits or receive checks from an annuity during retirement, these income streams are often taxable.

Roth IRA distributions are tax-free if you’re over the age of 59 and a half and have held the account for five years or more. That can be a welcome break when you’re adjusting to a fixed income for retirement.

3. Roth IRAs let you take full advantage of the power of compound interest

Why is investing so awesome in the first place? Because compound interest can turn even a modest contribution stream into a hefty nest egg.

Since you’ll be taking those distributions tax-free, a Roth IRA lets you take advantage of that growth as much as possible by allowing you to keep more of your capital gains.

4. Roth IRAs don’t carry an age limit

Even children can make Roth IRA contributions, which means you can get your family to start saving up as soon as possible.

You also can name a child as a beneficiary to your Roth IRA, passing down your savings.

5. Roth IRAs offer more favorable benefits for heirs

If you are planning to name a beneficiary to your account rather than taking the distributions yourself, a Roth will offer your heir more tax benefits. She’ll inherit tax-free money rather than the big, fat tax liability she might incur from other types of assets.

Keep in mind, however, that inherited IRAs are subject to required minimum distributions, even if they’re Roths, except when the account is transferred from a spouse.

6. There’s a backdoor Roth IRA option for high-income earners

As mentioned above, income limits do apply to Roth IRAs. If you’re a relatively high earner, you’re ineligible to fund a Roth directly.

However, you can take advantage of the “backdoor Roth” option. You simply open and fund a traditional, nondeductible IRA and then transfer the assets and reap the benefits of the Roth’s unique set of financial advantages.

7. Roth IRAs aren’t subject to required minimum distributions (RMDs)

Most retirement accounts, including traditional IRAs, require you to begin taking distributions once you reach the age of 70 and a half, putting a limit on your saving and earning potential.

Roth IRAs, however, allow you to leave the assets invested as long as you desire, even if that means your entire lifetime.

Roth IRA vs. traditional IRA: which is right for you?

Although Roth IRAs do carry some special benefits you won’t receive with other types of retirement accounts, contributing to a traditional IRA is still an excellent way to save for the future. Although your distributions will be taxable, many individuals expect to be at a lower income tax bracket when they reach retirement anyway. In other words, you might not be subject to as much of a tax liability as you would be for contributing to a Roth today.

Traditional IRAs are available no matter how much income you earn, making them an attractive savings vehicle for high-income earners. No matter which kind of account you choose, one thing’s for certain: Saving for retirement is non-negotiable, and the earlier you start, the better.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Jamie Cattanach
Jamie Cattanach |

Jamie Cattanach is a writer at MagnifyMoney. You can email Jamie here