How does my workplace retirement plan work?
A retirement plan offered by your employer can be one of the best and easiest ways to save. By understanding payroll deduction, tax advantages, investment options and fees, you’ll be on your way to making the most out of your plan.
Like health insurance or vision coverage, your employer may offer a retirement plan as an employee benefit. Usually this plan is called a 401(k), but may also be a 403(b) or a 457 plan. The numbers simply reference the Internal Revenue Code that allows for the benefit.
By enrolling in the benefit, you’ll choose an amount to automatically deduct from your pay that goes into the savings plan. Typically, a deduction is in the form of a percentage. So if you make $1,000 in a pay period, and choose a 5% deduction, you’ll be paid $950 while the other $50 goes into your savings plan.
Why it’s great
Not only is your contribution automatic, but it comes with a tax advantage. Most plans deduct money pre-tax, which lessens the taxes you pay that pay period, and helps you save more for retirement. The money isn’t taxed until you withdraw it, likely in retirement. That’s years of money growing tax-deferred and capitalizing on the long-term savings benefit of compounding interest.
To sweeten the deal, your employer may offer a matching contribution. While this option varies from company to company, an employer match is free money for you. If your company offers a 3% match, for example, it's like getting a 3% raise.
How savings are invested
Like any savings account, your money goes into investments that can help it grow. Your employer offers a number of investment options to choose from, which are generally invested in mutual funds such as stock funds, bond funds and cash equivalent funds. Investments differ in risk, potential reward, and fees. It’s up to you how to invest, but most plans offer some guidance to help you along.
Fees and expenses to be aware of
While your workplace retirement plan can be a super way to save, there are fees associated with your plan that can impact your savings. You should be aware of plan administration expenses, individual expenses, and investment-related costs.
Plan administration expenses
Plan administration expenses cover the overall administrative costs of the plan. These costs include operational expenses such as recordkeeping, trustee services, and often legal and accounting costs. Depending on your plan, your employer may pay these expenses so you don’t have to.
Individual expenses are for services that are provided to you individually, such as taking a plan loan or distribution. If you don’t use a particular service, the fees don't apply.
Investment-related costs are the fund operating expenses such as expense ratios or redemption fees. These are the fees and expenses that most significantly impact your account.
More about investment-related costs
Each investment option in your plan has an expense ratio. This is the annual amount you’ll pay to cover the fund’s operating expenses and management fees. An expense ratio is displayed as a percentage, and typically ranges from 0 to 2%. When looking at plan statements, you’ll be able to see how well each investment is performing. Just remember that the returns you see have already taken out the fee for the expense ratio.
Redemption fees can occur if you buy and sell an investment within a short time frame, typically 30 to 60 days. Because retirement savings plans are long-term investments, most people don’t buy and sell funds frequently enough to worry about the fee. Still, keep it in mind when making fund transfers in your plan.
Keeping track until retirement
As the years go on, you’ll want to monitor the progress of your savings. Here are a few more things to consider:
- Make it a goal to save up to the company match. There’s no better way to increase your savings.
- Try to increase your savings amount. A good time to do this might be whenever you get a raise.
- Consider investments that are appropriate for your age and risk tolerance.
- Avoid withdrawals and loans if possible. It should benefit you in the long run to keep your nest egg intact.
- Monitor your retirement account at least annually.
Money can be withdrawn from a workplace retirement plan without penalty when you reach retirement age. Plan rules differ on retirement age, but generally you can start withdrawing funds at age 59 1/2 if you’re retired. You aren’t required to withdraw funds until age 70 1/2.
The bottom line
Your workplace retirement plan is intended to be one of the easiest and smartest ways to save for retirement. Tax advantages, more money from your employer, and flexibility of investment options are all great reasons to save. If your employer offers a retirement plan, consider enrolling as soon as you’re eligible.