How to Set Up Your First 401(k)

401(k) decisions at your first job can impact your ability to retire.

By + More

New college graduates have many expenses competing for their limited paychecks. Student loan bills, food, rent, and utilities can easily consume a starting salary. But 20-somethings have one very important thing going for them. Young people are in the best position of their lives to start saving for retirement. Here's how to set up your first 401(k):

Start early. Money you tuck away for retirement in your 20s has decades to compound. Make savings automatic, beginning with your first paycheck and try to ramp up your contributions whenever you get a raise. "Our goal for new employees just getting into the workforce is we want to get them to save 10 percent of their gross wages as soon as possible," says Mark Berg, a certified financial planner and president of Timothy Financial Counsel in Wheaton, Ill. Those who can't afford 10 percent right away can start smaller. "We try to target 4 to 5 percent initially and then as they get raises, we'll add a percent or two to the amount they are putting in," says Berg. If your company has a waiting period before new employees are allowed to join the 401(k) plan, make note of that date and begin participating as soon as you are eligible.

[See 21 Ways to Cut Expenses in Retirement.]

Get a 401(k) match. An employer match is a powerful incentive to participate in a 401(k). A company match of 50 percent of contributions up to 6 percent of pay for an employee earning $35,000 annually can boost their retirement savings by $1,050 each year. If your employer doesn't offer a 401(k) match, it's still worthwhile to invest in a 401(k) for the tax break. Young employees can contribute up to $16,500 to a 401(k) in 2010 and defer the income taxes on the amount contributed until retirement.

Consider a Roth 401(k). Some companies offer a choice between traditional and Roth 401(k)'s. Traditional 401(k) deposits give you a tax break for the year you make the deposit, but income tax is due when the money is withdrawn. Roth 401(k) contributions are made with after-tax dollars and withdrawals in retirement are tax-free. The Roth option can be a good deal for young people who are currently in a low tax bracket. "People who potentially will retire in a higher tax bracket than they are in right now should use a Roth," says Clark Kendall, a certified financial planner and founder of Kendall Capital Management in Rockville, Md.

Scrutinize autopilot settings. Many large companies now automatically enroll new employees in retirement accounts unless they opt out. The most common default investment is a target-date fund. But the default investment strategy may not be right for everyone. Pay attention to how much is being deducted from your paycheck, how that money is being allocated, and what fees you are being charged. Employees must be given periodic opportunities to make changes.

[See Generation Y: Save for a House or Retirement?]

Pick diversified investments. New investors have an opportunity to buy into the stock market at low prices and benefit from rising equity values as the economy recovers. Choose a mix of stock funds, bonds, and cash that fits your personal risk tolerance. If your portfolio loses money in your 20s, you have plenty of time to recover before retirement. Pay attention to the fees and expenses associated with the investments offered by your company, which can cut into your returns dramatically over time. "If the provider offers low-cost index funds, indexes are a nice, low-cost way to build a diversified portfolio," says Berg. Also, make sure you don't overinvest in your own company by holding too much company stock. You don't want to tie too much of your retirement savings to the company. "We recommend not to have more than 5 percent invested in any one company stock," says Donald Nicholson Jr., a certified financial planner for Donald W. Nicholson & Associates in Wilmington, Del.

Balance retirement with other expenses. It can be difficult to save for retirement when you also have student loan payments. While it's a good idea to pay off credit cards or other high interest debt as soon as possible, student loans with low fixed interest rates don't necessarily need to be prioritized above retirement savings. "If you borrow money at 3 percent and can invest it at 4 percent, then you want to do that all day long," says Kendall. "If you borrow at 3 percent and invest at 2 percent, you are eventually going to go bankrupt." Also aim to accumulate an emergency fund of at least three to six months' worth of living expenses outside of your retirement account in case you lose your job or incur an unexpected expense.