What New Graduates Need to Know About 401(k) Plans

With summer comes a new class of graduates entering the workforce. They’ve passed. They’ve graduated. And they’ve landed a job. And now it’s time for these graduates to take on some serious adulting.

Naturally, this transition can bring some new and varied complexities, from choosing healthcare coverage to integrating into a workplace culture.

As odd as it may seem for the youngest of employees, one of the most important decisions is what to do about retirement, several decades away. Here’s where the 401(k) plan, offered by many companies, comes in.

A 401(k) is an employer-sponsored retirement plan that allows employees to contribute savings earmarked for retirement. Employers may also contribute money to these accounts, often through a company match, which is one of the most valuable benefits offered. The bottom line: If your company offers a 401(k), you should enroll.

First and Foremost, Opt In If It’s Not Automatic

The first step to investing in your 401(k) is enrolling in your plan. Some companies automatically enroll employees, but others require voluntary enrollment. Either way, it’s important to log in to your account and ensure the contribution percentage and investment choices are the best fit for you.

According to Vanguard’s “How America Saves” report, participation rates in 401(k) plans vary significantly depending on whether an individual is automatically enrolled in the plan or not. Vanguard shows auto-enrollment plan participation rates are 30% higher than those requiring voluntary enrollment. Don’t assume that you’re automatically enrolled; it’s important to be proactive and ensure enrollment upon starting a new job.

Consider Tax Treatment

Some employers offer both traditional and Roth 401(k)s. Fidelity’s Building Financial Futures Report shares that about 98% of plans now offer a Roth option, increasing from 75% in 2021.

Traditional 401(k)s invest pretax dollars; this reduces your taxable income in the year contributions are made, but withdrawals are taxed at retirement age. Roth 401(k)s do the opposite: They invest funds after taxes are taken out now, and withdrawals at retirement age are not taxed again. Early withdrawals from either plan incur penalties.

A traditional 401(k) works best if you will have a lower effective tax rate in retirement than today, and a Roth is better if you will have a higher effective tax rate. Predicting whether or not your effective tax rate will be higher or lower more than 40 years from now is basically a coin flip, but investors in the beginning of their careers should prefer a Roth if it’s available. Their salaries are likely at their lowest point, so their effective tax rate is probably only going to go up over time. Some also prefer a Roth because, once the taxes are paid, it’s one less thing to have to plan for in retirement. Most plans typically provide the option to split your contribution between both, and you can make changes throughout your career.

Unlock Your Company Match

While some companies will contribute to employee 401(k)s no matter what employees do, a company match is a benefit that kicks in only when you invest in your 401(k). It could be a dollar-for-dollar match up to a certain percentage, a percentage of the employee contribution, or a different structure altogether.

The chart above shows the impact of the company match over the long term. The hypothetical scenario compares employee-only contributions at a savings rate of 7% and employee contributions + company match, totaling a savings rate of 10%.

Savers should contribute at least enough to capture the full match, as doing so pays off right away, and more so at retirement age.

Take Advantage of Compounding

As shown above, 401(k) participation rates are lowest in the 25 & Under group, and significantly so when voluntary enrollment is required. While individuals in this age group are less likely to have disposable income for investing, there is a material advantage to investing early.

The chart above shows the difference in hypothetical 401(k) balances of two individuals with equal income, contribution rates, and returns on investments but who started investing in their 401(k)s at different times. While the difference in total contributions was only about $50,000 overall, the investor who began at age 25 accumulated nearly twice as much by age 65 as the investor who waited until age 35 to start investing.

The takeaway is to start contributing early. Even small investments early will allow compound interest to start working.

Save More, and Then More

Saving more now should produce higher balances later, but many investors aren’t saving as much as they could. According to Vanguard’s report, the average 401(k) savings rate for investors in the 25 & Under group is only about 5.5%; however, the average employee-elective deferral required to receive the full match was 6.4% of pay. This means many individuals are leaving money on the table, effectively reducing the value of their total compensation package.

The exhibit above shows the impact of an investor’s savings rate over the long haul. This chart assumes static contribution rates, but of course, 401(k) investors can adjust their contribution rate at any time. Many plans also offer auto-escalation, where participants elect for their contribution rates to increase automatically. This is especially helpful for investors who prefer a hands-off investing approach.

While investors preparing for retirement should save more, there are limits, depending on your age.

Choose Investments Wisely

If your company auto-enrolls you into its plan, the most common default investment is a target-date fund with a long-term investment horizon. Fidelity’s report notes that over 80% of Generation Z workers invest all their retirement savings in a target-date fund, making it the most popular investment option among young workers.

The automatic features within target-date funds can be especially helpful to newer investors. Target-date funds gradually shift from a more aggressive asset allocation (a combination of various stocks, bonds, and other investments) into a more conservative blend as the investor approaches retirement age. This means individuals can invest money for retirement without actively changing their portfolio.

Participants can also take a more active approach in setting up their own investment portfolio, choosing among other options offered by their plan. Whether sticking with the default investment or building your own portfolio, it’s always important to consider your personal goals, risk tolerances, and the fees associated with your investment choices.

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