The Essential 401k Step-By-Step Retirement Guide

step by step 401k retirement guide
“Your 401k could be your ticket to retirement. It’s worth your time to figure out how to use it.”
— Derive Wealth

Essential 401k Retirement Guide

Your 401k can be your gateway to retirement.  It can also be a gateway to extreme frustration. 

There are terms you have never heard before (asset allocation?) and decisions you have never had to make (salary deferral?)

Throwing up your hands and just laughing it off is one way to deal with it. 

But it doesn't have to be that way.  Your retirement is too important to leave to chance.  Follow this essential 401k retirement guide and never feel frustrated again.



Well, from the IRS tax code 401k, it states.....(snooze button.)

Here is what you need to know.  The government wants you to retire at some point.  But there is a certain way they would prefer you do it:

On your own.

The government would prefer not to have to take care of you during retirement (remember, social security was never meant to be your full retirement income, although many use it that way.)

So if you were in their shoes, how would you convince the working population to save for their own retirement?

Tax breaks.

Simply provide tax incentives to help the working population save for retirement.  In a nutshell, that's all a 401k is. 



A 401k works by taking money you would usually spend today and saves it for your future.  It is a simple trade off to forgo enjoyment of your paycheck today so one day you can create your own paycheck using your 401k savings.

It is a modern day piggy bank.

401k Savings

By taking a portion of your salary and setting it aside in your 401k, you hope one day you can use those savings to retire.

Contributing To Your 401k

Do it yourself guide 401k

Mr. Newbie, Manager of Marketing
- Age: 30
Salary: $72,000
- 401k Contribution: 10% of his salary


Meet Mr. Newbie, our first time 401k participant.  His first decision was deciding on how much to save.  



Your contribution type is simply how you want to fund your 401k.  To keep things easy with your payroll department, you are usually given two options:

- Percentage Based: A set percentage taken out of your paycheck (ex: 5%, 10%)
- Dollar Amount: A specific dollar amount taken out of your paycheck (ex. $100, $200)

Percentage based is the most common method.  It is easy to understand and also "flexes" with any fluctuations you may have in income. 

Percentage Based Example

Paycheck #1
Amount: $3,000
Contribution (10%): $300

Paycheck #2
Amount: $3,500
Contribution (10%): $350

Paycheck #3
Amount: $2,000
Contribution (10%): $200

As your income fluctuates with each paycheck, so does your 401k contributions using the percentage based method.  

Dollar Amount Example

Paycheck #1
Amount: $3,000
Contribution (fixed): $300

Paycheck #2
Amount: $3,500
Contribution (fixed): $300

Paycheck #3
Amount: $2,000
Contribution (fixed): $300

Dollar amount is usually used if you are looking to contribute a set amount.  You may want to contribute exactly $5k or $10k per year.  In this case, dollar amount would be your best bet.



This is the most important decision you will make.  How much you decide to contribute can have a direct correlation to when you retire.

This is also the toughest question to answer.  How in the world are you supposed to know how much you need to save? (hint: I can help you answer that question)

The most common method I see is budget based.  Simply you contribute an amount that fits into your budget. 

I'm a big believer in what I call a save first budget.  You start your budget by what you need to save, then mold your remaining expenses around your savings.  I know this is extremely hard to accomplish, but one of the best ways to stay on track for retirement.

To level the playing field, lets assume you select the percentage based contribution type.  Use the following as a guide:

How Much To Save (% of your salary)

Beginner: 1 - 3%
Intermediate: 3 - 7%
Advanced: 7 - 15%
Expert: 15% - 25%

It is completely fine to start at the beginner level and move up slowly.  That is exactly how the real world works.  Don't judge yourself on the labels. It may take years to move up to the next level.



The reduction in your take home pay is less than the amount you contribute to your 401k.  Remember when I said the government provides tax breaks to save in your 401k?  They come in the form of tax deductions.

To see how tax deductions effect your specific situation, I recommend you use a payroll calculator.  My favorite is from Dinkytown (funny name, I know).  You can use their 401k Contribution Effects On Your 401k Paycheck Calculator.

401k paycheck calculator

First, leave the retirement savings current box at 0% and change the retirement savings new box to the percentage you would like to start with.  Using Mr. Newbie as an example, we used 10%:

401k payroll calculator

The next section allows you to input your paycheck and income tax details.  To keep things simple, just focus on the following:

401k paycheck calculator

For gross pay, this is your per paycheck amount (not annually).  Pay period is the frequency you get paid (weekly, monthly, twice per month, every two weeks, etc.)  Your tax filing status is married, single, etc.

To find your specific state & local tax rate, you can use this guide.

Mr. Newbie's salary is $72k, which equals $3k twice per month.  He is single, has an average state tax rate of 8%, and expects a 3% salary raise each year (optional).

His results:

401k paycheck calculator


Tax Deduction Savings

Did you catch the difference?  Mr. Newbie contributes 10% of his salary, which based on his $3k twice per month paycheck, equates to a $300 contribution.

So you would think his paycheck would be reduced to $2,700 from $3,000.  But it is not.  His pay is reduced only by $201 to $2,799.

The $99 difference is his tax savings due to the 401k tax deduction.

Taxable Pay With & Without 401k

The amount you put into your 401k lowers your taxable income and escapes being taxed today.

You are effectively bypassing the tax system (for now) and putting the money directly in your pocket (to use for and taxed at retirement.)

Lets now check in with Mr. Newbie:

401k tax savings

Mr. Newbie, Manager of Marketing
- Salary: $72,000
Contribution: $300 per paycheck
- Tax Deduction: $300 per paycheck
- Paycheck Reduction: $201
- Tax Savings: $99



You may think this is crazy, but some people love the idea of a 401k so much they would like to save their entire annual pay.

But there are limits.  It's split between those under age 50 and those over age 50.

For 2017, for those under age 50 you can contribute up to $18,000 annually to your 401k.  For those over age 50, you can contribute another $6,000 annually on top of the $18,000.

This is the governments way of saying if you are late to the game, you better hurry up and catch up!



Get rewarded with free money for saving for your own retirement.  Sweet deal, right? Your employer may provide a match to help incentivize your savings.

An employer match is the amount of money your employer will contribute on your behalf.  They are giving you money from their pockets to put into your own 401k.  It is as good as it sounds.

Employer matching is usually done in one of two ways:

- Flat Percentage: Up to a certain percentage amount (example: 3% of your salary)
- Complex Percentage: Two percentages involved (example: 50% of your contributions up to 5%)

Flat Percentage Employer Match
(3% match dollar for dollar)

Paycheck Amount: $3,000
Your Contribution: 10% ($300)
Employer Match: 3% ($90)
Total Contribution: $390

Paycheck Amount: $3,000
Your Contribution: 1% ($30)
Employer Match: 1% ($30)
Total Contribution: $60

In the first example, your employer will match up to 3% of your contributions.  If you are contributing 10%, you will receive the full match.

In the second example, if you are contributing less than the match, in this case 1%, you only receive a 1% match.

If you are offered a match under this structure, keep it simple and contribute at least up to the maximum match level.

Complex Percentage Employer Match
(50% match dollar for dollar up to 5%)

Now things get a little more complicated.  Your employer may not want to match at the same level of your contributions.

They may want you to have more skin in the game to get the full match.  Sound complicated?  It is.

A common structure is a 50% match dollar for dollar up to 5% max.  This is a complicated way for your employer to say they will match 50 cents for every dollar your contribute, up to a max of 5% of your salary.

Here is how it works:

Paycheck Amount: $3,000
Your Contribution: 10% ($300)
Employer Match: 50% up to 5%: ($150)
Total Contribution: $450

Paycheck Amount: $3,000
Your Contribution: 5% ($300)
Employer Match: 50% up to 5%: ($75)
Total Contribution: $375

In the first example, you put in 10%, and your employer puts in 5%, or half of what you put in.  They have matched 50 cents for every dollar you put in up to a maximum level.

In the second example, you put in 5% and your employer puts in half, or 2.5%.  In this case, you are not receiving the full match.  You would need to contribute 10% to receive the full match.

This structure makes you put in quite a bit more of your own money to receive the full employer match.



Your employer may put restrictions on when your matching contributions are 100% yours.

Matching contributions go into your account right away and can be invested.  Vesting consequences only take place if you decide to leave.

This helps protect employers from the one and done situation. You work for them 1 year, receive a match, then bolt.

Vesting is a fancy term for saying there is a set time period which there will be penalties if you decide to leave your employer.  It only affects matching contributions.  The money you put in from your own paycheck is always 100% yours.

Think of vesting just like a Certificate of Deposit (CD) at the bank.  You could buy a 1 year, 3 year, or longer CD that has restrictions if you want to liquidate early.

Vesting is usually split into three categories:

Immediate Vesting: No restrictions
Graded Vesting: A pro-rated schedule based on your employment anniversaries
Cliff Vesting: No vesting for a set period then 100% vesting

Immediate Vesting

Simple to understand, the match you receive is 100% yours at all times.  This is rare, but a few employers use this as a competitive advantage to attract and (hopefully) retain employees.

Graded Vesting

Based on your employment anniversary dates, your matching contributions become available to you on a prorated basis.

Usually a graded vesting schedule goes from year 1 to 6, with 20% increments becoming vested each employment anniversary.

Graded Vesting Schedule

Let's assume you decide to change jobs after 3 years.  Any money you put into your 401k from your paycheck is 100% yours.  You would also receive 60% of your employer match, or 20% accumulated each year you worked.  The remaining 40% would be kept by your employer.

Cliff Vesting

I don't see this often, but cliff vesting is just like how you would visualize it: there's a cliff you encounter at some point in time.

In this case, the cliff is when you become 100% vested.  Up until you see the cliff, you are 0% vested.

Usually cliff vesting is on a 3-year schedule, with year one being 0%, year 2 being 0%, and year 3 being 100% vested.

Cliff Vesting Schedule

If you left your employer after 1 or 2 years, you would not receive any of your employer match.  Once you complete 3 years, the match is 100% yours.



With everything you now know, consider taking the following steps:

1. Use the percentage based method
2. Select a level that fits into your budget
3. Use the payroll calculator to see the effects on your take home pay
3. If your employer matches, select a percentage that takes full advantage
5. Check your vesting schedule to know when matching is 100% yours

And Mr. Newbie now stands:

essential 401k retirement guide

Mr. Newbie, Manager of Marketing
- Salary: $72,000
Contribution: 10% of salary
- Under Contribution Limit: Yes
- Employer Match: 3% dollar for dollar
- Vesting Schedule: Graded over 6 years

Investing Your 401k

This is actually easier than you think.  At this point it's more imperative you understand the concepts of investing than the actual definitions.  Let me explain.



Your 401k is designed to be a long term investment. Long term is often defined as 10 years or more.  Depending on your age, your long term could easily be 2-3 decades.

But just because 401k's are labeled "retirement accounts" doesn't mean everyone will use them that way.  

To try and ensure you use your 401k the way it is designed, the government imposes an early withdraw penalty.

10% Early Withdraw Penalty Under Age 59.5

If for some reason you need to withdraw your funds out of your 401k, you will owe state and federal income taxes plus a 10% penalty, unless you qualify for an exclusion or do a loan.

This is not to discourage you from investing, rather to help remind you to stay the course.

Use This To Your Advantage

It will cost you to just cash out and run when the stock market spooks you. 

Here's a conversation I have all too often:

Mr. Newbie: "The market is going down, I should sell everything in my 401k."

Me: "Why would you do that?"

Mr. Newbie: "Well I just don't want to lose money."

Me: "But you don't need your 401k funds right now.  They are designed for your retirement.  In fact, you can't touch them until you reach at least 59.5 without penalty.  That's 29 years for you."

Mr. Newbie: "I understand.  But I want to make sure I don't lose any money today."

Me: "So you are worried about money you are going to use 29 years from now?"

Catch my drift?  

Why Long Term Investing Works

Check out this post on investing for the long term and the history of the stock market.



To keep things simple use an investment fund that is already fully diversified for you.  I like asset allocation funds or target date funds.

Now there is plenty of criticism out there regarding these funds, but usually they are surrounded around those who want more control.  

If you are the type that likes to build your own dinning room table by chopping down the tree, sanding and cutting, screwing and gluing, and priming and painting, then these funds are not for you.

However if you feel that a table pre-made at Crate and Barrel is more convenient for you and still meets your needs, then these will be just fine.

Here are your options in more detail:

Make Your Own Portfolio

Sample Investment Options
U.S. Stock Funds
International Stock Funds
U.S. Bond Funds
International Bond Funds
Real Estate Funds
Commodities Fund
Money Market
Company stock


This route gives you full control but also the most responsibility.  You are in charge of doing your own research, selecting the right funds, rebalancing, and the timing of making changes.

Use A Pre-Built Portfolio

Investment Options
Asset Allocation Funds
Target Date Funds

This option is what is usually called a fund of fund approach.  Instead of you selecting a variety of funds as outlined above, you can purchase one fund that already has a variety of funds in it.

This makes life a lot easier, right?  Let's examine these funds in greater detail. 



Asset Allocation Funds

A quick background of what "asset allocation" means:

Asset: Describes the type of investment (usually stock, bond, cash, real estate, gold, etc.)
Allocation: The proportion invested in each (30% stock, 30% bond, 5% cash, etc.)

Asset allocation to investing is like a recipe to cooking.  It just outlines what goes into the final output.  

Just like cooking, you could have a mild, medium, or hot recipe.  For investing, you could have a conservative, balanced, or aggressive asset allocation.

Make sense?

Every 401k plan has slightly different labeling, but most asset allocation funds have a common denominator in their title:

Conservative (less stocks)
Moderately Conservative
Moderately Aggressive
Aggressive (more stocks)

How to know which to select is a personal decision.  An easy way is to select an allocation that best matches how you view your money.

This may help you sleep at night, but may not get you to your retirement goals.  Another way to look at this is by time frame to your retirement date:

Conservative: 3 years or less
Moderately Conservative: 5 years or less
Balanced: 7 years or less
Moderately Aggressive: 10-15 years
Aggressive: 15+ years

Depending on when you expect to retire, you could select the corresponding fund.

Target Date Funds

There is an easier way.  The one problem with asset allocation funds is you are in charge of deciding when to move down in risk as you get closer to retirement.

For example, if you start with moderately aggressive, when should you move down to balanced?  You need to make that call.

Target Date funds are designed to do exactly that for you.  They are asset allocation funds that become more conservative, or move down the risk spectrum, over time.  And it happens automatically.

Target Retirement Date 2020
Target Retirement Date 2025
Target Retirement Date 2030
Target Retirement Date 2040
Target Retirement Date 2050

The numbers you see are designed to closely match the year you may retire.

For example, if you are 30 right now and looking to retire at age 60, you are 30 years away.  Adding 30 years to today (2017) would be the year 2047.

You could select the Target Retirement Date 2050 fund as it closely matches.  As you get closer to your retirement date over time, the fund will become more conservative automatically.

Check out how a target date fund becomes more conservative over time based on age.

Target Date Fund Glide Path

The farther away you are from retirement, the more aggressive target date funds are.  This is key to understand.  You are not investing based on your comfort level, but rather based on your age.



Target date funds are also used as what's referred to as a qualified default investment alternative (a.k.a. that piece of paper they mail to you and you have no idea what it means).

This only comes into play if you forget to select an investment option.  If this happens, your company will do so for you, most likely based on your age and using the corresponding target date fund.



While there are other ways to invest, when you are just getting started, I recommend using one of the above.  Your thought process should be:

1. Asset allocation funds match your investment style with your comfort level
2. Target date funds match your investment style with your age
3. Target date funds become more conservative over time
4. Asset allocation funds stay static at their designed risk level

Let's do a quick check in with Mr. Newbie:


Mr. Newbie, Manager of Marketing
- Age: 30
- Expected Retirement: Age 60
- Expected Retirement Year: 2047
- Investment Preference: Age Based
- Target Date Selected: Retirement Date 2050

Accessing Your 401k

The hard part is over!  You can now sit back, relax, and enjoy the ride.

But now you may be wondering, how can I take my money out?

1 | After Age 59.5

Once you reach age 59.5, you can withdraw money anytime without penalty.

As I mentioned earlier, your 401k is designed as retirement account.  In the governments eyes, retirement is anytime after age 59.5.

You can simply withdraw money from your 401k just like you would any other investment account. 

Just remember any money you take out is 100% taxable to you.  Remember the tax deductions I mentioned earlier?  It is now time to pay up.

2 | Loans

A 401k loan can give you temporary access to your funds in case emergencies or opportunities too good to pass up.

I usually advise against taking 401k loans, but understand when the need arises. 

If you take your retirement seriously, you may be contributing quite a bit to your 401k and have accumulated a significant balance.  It may be your only place to go to cover a large expense.

The details you need to pay attention to are:

- Loan Amount
- Repayment Period & Frequency
- Interest Rate
- Orgination Fees

The scope of these details are intensive and I highly recommend you meet with your HR department to make sure you understand fully how loans work.

3 | Hardship Provisions

The government recognizes you may need to make a permanent withdraw (unlike a loan that is repaid) from your 401k.

You can do so under the hardship provisions.  Similar to loans, there are specific details you need to be aware of and follow.

Hardship provisions usually fall under these categories:

- Medical Expenses
- Buying A Home
- Tuition & Educational Costs
- Preventing Eviction or Foreclosure
- Funeral Expenses

To qualify, you must demonstrate your hardship and often times show your other resources have been exhausted.

4 | Substantially Equal Periodic Payments

A very technical tax strategy to take money out of your 401k before age 59.5 without the 10% penalty.

I mention this as it is a strategy you should be aware of, but the fine print is major.  It's best left to a professional to help guide you through.


Ready To Conquer Your 401k?

Congratulations!  You now have what it takes to feel confident about managing your 401k.  But you are not alone.  If you need help, don't hesitate to me a shout.  


Derive Wealth is an independent, 100% fee-only financial planning firm located in Pasadena, CA.  We specialize in creating personal financial plans designed to organize your life, get you to your goals, and take the worry out of your money.  We don't sell products and don't work on commissions. Instead, we provide financial advice you can believe in.