A Complete Guide to Investing in 401(k) for Beginners

401(k) Explained for Beginners 

Before we get into specific 401(k) tips for beginners, let’s talk about the basics. It’s an employer-sponsored pension savings plan or investment-based retirement account. It is offered by many employers in the United States as a way for them to attract more people into the workforce instead of them sitting on the couch and eating Cheetos (until they run out of Cheetos).

This type of account has been around since 1978 and its name comes from the respective section of the Internal Revenue Code. When an employee signs up for a 401(k), they agree to have a percentage of each paycheck sent to their 401(k) account.

In addition to tax benefits, some employers will match the employee’s contribution amount, terms and conditions apply. Sounds like communism you may say! But the employers benefit from this as well. They get tax credits and write-offs, their employee turnover goes down and their workforce becomes fitter, happier, and more productive.

There are two types of 401(k) accounts: traditional 401(k) and Roth 401(k).

Traditional 401(k) is funded with pre-tax dollars, so you’ll get a tax deduction against the contribution amount and you won’t have to pay tax on your investments until you start making withdrawals.

The Roth 401(k) is taxed like a Roth IRA: the contributions are after-tax, so you won’t get a tax deduction, but the distributions after you retire will be tax-free.

This will mean additional stonks when your tech portfolio — full of Amazons of tomorrow — grows 10,000x by the time you’re 59½ years old. But fill your portfolio with AltaVistas and Compaqs and you can end up losing money. So for some people, it might be a good idea to have both traditional and Roth 401(k) but discuss this with your wealth manager / spouse / investor friend and make sure you have a plan.

If you work for a non-profit or a government agency, you will not be eligible for a 401(k), but you might have something similar called the 403(b) plan.

Additionally, if you are a small business owner or self-employed like an independent contractor, you can get something known as a solo 401(k), a relatively new type of retirement account that has many benefits over the alternative retirement plan for small business owners — the SEP-IRA.

How Does a 401(k) Work? 

So how does a 401(k) actually work? Before you think about investing in 401(k) for beginners, first go get a job. Once you have that, you can opt for a 401k and choose a plan.

Employer matching

Besides the tax advantages, the key benefit of a 401k account is that your employer will match your contributions. Typically it will be something like 50% of your first 6% but this can vary. So for every dollar you put in, your employer will match it with 50 cent. This is called a partial match.

Sometimes employers offer a dollar-for-dollar match. This means your employer’s contribution will match your contribution. But in this case, the maximum percentage is lower, usually 3%. 

So what’s the difference between a 50% match on 6% of your salary and a 100% on 3% of your salary? Even though you’ll have the same amount in your 401(k) account, technically the latter is better because you keep more of your salary. But you’ll have to consider the bigger picture like how much extra tax you’ll end up paying and other details of the plan.

Some employers vest contributions over the course of several years or whatever the vesting period is. This means you have to stay for a certain period of time until you can claim your employer’s matching contributions. Once you’ve completed this period you become what’s known as “fully vested” and now you can finally cash out your contributions and run to Mexico. Just kidding, not so fast, Dobby.

Withdrawals

All retirement accounts, including 401(k) actually have pretty strict early withdrawal rules. You’ll usually end up paying a 10% tax penalty, so it’s really not worth it unless you really need the money.

However, many 401(k) plans allow the holder to take out a loan of $10k or 50% of the balance, whichever is greater. These loans cannot exceed $50k and have to be repaid within 5 years, usually in quarterly payments.

The good thing is that — if you really need the cash — all these payments and the interest you accrue get returned to your account. So it’s like a free loan unless you fail to repay it, in which case it might end up being considered an early withdrawal. In addition to this, you might not be able to make 401(k) contributions until your loan is paid off. So it’s really not recommended but it is an option.

Limits

The maximum you can contribute to a 401(k) is $20,500 in 2022. That’s unless you’re 50 or older, then you can contribute an extra $6,500. On October 24, 2022, the IRS announced the updated contribution limits for 2023. The basic limit will be $2k higher at $22,500 plus an additional $7,500 for over-50s.

You can have both a traditional and a Roth 401k and you can split up your contributions as you like as long as you don’t exceed these limits. The employer’s contributions will come on top of this. In fact, if you have a Roth 401k and contribute after-tax dollars, your employer’s contributions will be placed in a traditional 401k anyway because the IRS requires you to pay regular tax on withdrawals of employer contributions.

Changing jobs

When you leave your job, you have several options. If you’re changing to a new workplace, you’ll be able to take your 401(k) account with you. As long as you’ve completed the vesting period you’ll be able to keep your employer’s contributions as well.

Another option is to move the account to a Rollover IRA, which lets you protect your retirement funds from taxes.

If you’re done with the government altogether and just want to get off the grid, take psychedelics and open a crypto-only pancake stall instead, you can close the account and take all your money minus the early withdrawal penalties. Who cares, hopefully you’ll have enough saved for a Volkswagen Bus.

How to Pick 401(k) Investments?

When you sign up for a 401(k), you’ll usually have the ability to choose an investment option for your money. While you typically can’t invest in specific stocks or other assets, the question about how to pick 401(k) investments is still an important one. Depending on the account provider your company works with, you can usually pick between a handful to a dozen mutual funds or exchange-traded funds (ETFs). 

Some of these can be actively managed and some will be index funds like the S&P 500 that track the broader market.

By default, you are likely to be enrolled in some kind of default option like a target-date fund, which will rebalance your portfolio as you get closer to your target date — usually the year of retirement. You can keep the default option or choose other options that are available to you depending on your risk tolerance and investment timeline. Even though there isn’t that much flexibility there still may be some good 401(k) investment options for beginners.

The funds you pick will usually have names like income, growth, conservative, aggressive growth, and so on. You’ll be able to find out more information about them from your account provider to find out which one will work best for you. Maybe they even have a detailed investment guide for 401(k) for beginners breaking down the options they have.

How to Build Your 401(k) Portfolio?

Even though the number of options in a 401k is very limited in comparison to a usual brokerage account, there are some important steps you can take to make sure you have full control over your portfolio. In any case, if you’re starting out your company may have enough 401(k) investment options for beginners.

Write down your financial goals

Because it’s a retirement account, its main purpose is to give you a comfortable retirement. Consider your current salary and existing savings, the number of years until you expect to retire, the potential inflation rate and what you can expect to earn on your investments when inflation is taken into account.

Work out your risk tolerance and time horizon

The number of years left until you retire will be the main factor in defining how much risk you can handle. The key thing is to think long-term.

Diversify

Avoid having too much of just one type of asset. It’s a good idea to mix up things like an S&P 500 fund and allocate a portion of your portfolio to more aggressive assets like medium-cap and small-cap companies. Of course, the flexibility will depend on what is available to you at your workplace.

If your provider doesn’t give you the options you need, it might be a good idea to look elsewhere and maybe stick to the conservative assets on your 401(k) plan.

401(k) Tips for Beginners

If you have a 401(k) but haven’t logged on to set it up, your investment portfolio may not be doing anything even if you’re sending contributions. So talk to your HR rep, especially if you don’t know how to actually log into the system. They should be your first point of contact to get 401(k) help for beginners. They may be able to suggest some good beginner 401(k) investments depending on what’s available to you.

The biggest benefit a 401k has over other types of investments is the employer match. Paying less tax is also great, but the match is where you get the most ROI. If we were to only give one tip around 401(k) for beginners it would be this one. Use it to your advantage and think if it’s worth putting more money in your account above the matching maximum your employer offers. It might be worth looking elsewhere.

Another thing to keep in mind is fees. You will have to pay fees for your 401(k) account. These are usually between 0.5% and 2%. The typical annual fee for most funds is 1%, and anything above that might not actually be worth it if you take everything into account.

Final Thoughts

Having a 401k account is a nice way to prepare for retirement, especially if you take full advantage of the tax breaks and employer’s matching contributions.

Early withdrawals can be costly, so make sure you do your best to avoid putting too much in your retirement account.

There are other options available to you if you’re likely to change jobs. For example, an IRA account. Or think outside the box and start your own business instead of working for an employer your whole life.

There are also other ways to build a great portfolio without relying on someone else to make all the decisions for you.

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