The Employer Match, the Order to Save In, and Fees

Knowing the accounts is half the job. The other half is deciding which to fill first, what to hold inside them, and how much the costs take. This chapter covers the employer match, a common order for spreading savings across accounts, a simple way to invest, and why fees that look tiny can delay retirement by years.

The employer match comes first for most people

Many employers add money to your 401(k) when you contribute. The formula is set by the plan and usually has two parts: a match rate and a cap. A plan that matches 50% up to 6% of pay adds half of what you contribute, on contributions up to 6% of your salary. Contribute 6% and the employer adds 3% of your pay. Contribute 3% and you get only 1.5%. Another common formula matches 100% of the first 3% of pay and 50% of the next 2%, so contributing 5% earns a match of 4%.

The match is part of your pay, and you only receive it if you contribute. That is why so many guides put it first: few other uses of money offer an immediate return of 50% or 100% on the dollar. The 401(k) contribution and match calculator shows the match you get at your current rate and how much you leave behind.

Three details decide how much the match is really worth.

Vesting. Your own contributions are always yours. Employer contributions may vest over time, which means you keep them only after a set period of service. Federal rules allow employer contributions in a 401(k) to vest on a schedule of up to three years all at once, or gradually over two to six years. Your plan's summary plan description states the schedule. If you are thinking of changing jobs, check how close you are to the next vesting date.

Per-paycheck matching. Some plans calculate the match each pay period. If you contribute heavily early in the year and reach the yearly limit before December, you may miss the match on later paychecks unless the plan makes a year-end correction, often called a true-up. Ask the plan administrator whether it does.

The cap is on pay, not dollars. The match is a percentage of salary, so it grows when your pay grows, up to a federal limit on the pay a plan can count.

A common order for filling accounts

Once you know the match, the next question is where each additional dollar should go. There is no single correct order, but this sequence is widely used because each step usually offers a better deal than the one after it.

1. A starter emergency fund. A small cash cushion keeps an unexpected bill from turning into high-interest debt or an early withdrawal with penalties.
2. Contribute enough to get the full match. This is the highest return available to most savers.
3. Pay off high-interest debt. Paying off a credit card that charges a high rate is a guaranteed return equal to that rate, which is hard for any investment to beat reliably.
4. A health savings account, if you are eligible. An HSA paired with a high-deductible health plan has tax advantages that can exceed a 401(k)'s. Volume 2 on this shelf covers how to use it for retirement.
5. An IRA. Often a Roth IRA, for the flexibility and the wider choice of low-cost funds described in chapter 4, if your income allows.
6. More in the 401(k), up to the limit.
7. A taxable brokerage account for anything beyond that, or for goals before retirement.

The order shifts with circumstances. If your plan has very high fees and no match, an IRA may come before the 401(k). If you have no high-interest debt, step 3 drops out. If you expect to need money before 59½, more of it may belong in a taxable account or a Roth IRA, whose contributions can be withdrawn. The order is a starting point for judgment, not a rule.

What to hold: keep it simple

Inside the accounts, you choose investments. Research on fund performance has repeatedly found that most actively managed funds trail low-cost index funds over long periods, mainly because of their higher costs. For most savers, a simple low-cost portfolio is both easier and more likely to work.

Target-date funds. One fund holds a mix of stock and bond index funds and gradually shifts toward bonds as the target year approaches. You pick the fund dated nearest your expected retirement year and the fund does the rebalancing. Costs vary widely between providers, so compare the expense ratio.

A three-fund portfolio. A total US stock market index fund, a total international stock index fund and a total bond market index fund cover thousands of companies and bonds. You decide the split and rebalance yourself, usually once a year. The asset allocation calculator helps choose a split for your age and risk tolerance, and the rebalancing calculator shows the trades to restore it.

Whichever you choose, the main risks for a long-term saver are holding too little in stocks for decades, concentrating savings in a single company (including your employer's stock), and selling after a fall.

Fees: the cost you do not see

Investment costs are quoted as a percentage of your balance each year, so they look small. Over decades they compound in the same way returns do, but against you. The example below compares the same saver with and without an extra 1% a year in costs, the kind of difference that can separate an expensive managed fund from a low-cost index fund.

Saving $1,000 a month toward a target of $1,000,000, the saver who keeps 7.0% a year after costs gets there in about 37.6 years. With one more percentage point in costs, the net return falls to 6.0% and the same target takes about 42.6 years. Nothing else changed.

Costs to look for are the fund's expense ratio, any sales charges, and in some workplace plans an administrative or advisory fee charged on top. The US Department of Labor publishes a plain guide to 401(k) fees, listed in this chapter's sources. The investment fee calculator shows the cost of any fee over your own horizon.

Changing jobs without losing ground

When you leave an employer, you usually have four choices for the old 401(k): leave it where it is (if the balance is large enough for the plan to allow it), roll it into the new employer's plan, roll it into an IRA, or cash it out. Cashing out before 59½ generally means income tax plus the additional 10% tax, and it removes the money from tax-sheltered growth for good.

If you move the money, ask for a direct rollover, paid from one account to the other. If the old plan pays the money to you instead, it must withhold 20% for tax, and you have 60 days to deposit the full amount, including the withheld part from your own funds, to avoid tax on the difference. Remember also the age-55 exception from chapter 4, which applies to a workplace plan but not to an IRA.