If you are among the millions of Americans who contribute to a 401(k) plan, you receive a quarterly account statement composed of dull, incomprehensible financial prose. However, you want to maximize your contributions—so you'll need to understand the types of investments offered in these investments.
Learn more about 401(k)s, which are best suited for you, and how to manage the account going forward to maximize your returns.
- 401(k) plans typically offer mutual funds that range from conservative to aggressive.
- Before choosing, consider your risk tolerance, age, and the amount you’ll need to retire.
- Avoid funds with high fees.
- Be sure to diversify your investments to mitigate risk, although many funds are already diversified.
- At a minimum, contribute enough to maximize your employer’s match.
- Once you have established a portfolio, monitor its performance and rebalance it when necessary.
Fund Types Offered in 401(k)s
Mutual funds are the most common investment option offered in 401(k) plans, though some are starting to offer exchange-traded funds (ETFs). Both mutual funds and ETFs contain a basket of securities such as equities.
Mutual funds range from conservative to aggressive, with plenty of grades in between. Funds may be described as balanced, value, or moderate. All of the major financial firms use similar wording. Here is a list of the types of fund strategies you might find:
- Conservative Fund: A conservative fund avoids risk, sticking with high-quality bonds and other safe investments. Your money will grow slowly and predictably, and you would rarely lose the money you put in, short of a global catastrophe.
- Value Fund: A value fund is in the middle of the risk range and invests primarily in solid, stable companies that are undervalued. These undervalued corporations usually pay dividends, which are typically quarterly cash payments but are expected to grow only modestly.
- Balanced Fund: A balanced fund may add a few more risky equities to a mix of mostly value stocks and safe bonds, or vice versa. The term "moderate" refers to a moderate level of risk involved in the investment holdings.
- Aggressive Growth Fund: An aggressive growth fund is always looking for the next Apple (AAPL) but may find the next Enron instead. You could get rich fast or poor faster due to wild swings between big gains and losses.
- Specialized Funds: In between all of the above are infinite variations. These may include specialized funds, investing in emerging markets, new technologies, utilities, or pharmaceuticals.
- Target-Date Fund: Based on your expected retirement date, you may choose a fund intended to maximize your investment around that time. As the fund nears its target-date time frame, investments change toward the more conservative end of the investment spectrum.
What to Consider Before Investing
You don’t have to pick just one fund. Instead, you could spread your money over several funds. How you divvy up your money—or your asset allocation—is your decision. However, there are some things you should consider before you invest:
- Your risk tolerance
- Your age
- How much you need
The first consideration is highly personal, your so-called risk tolerance. Only you are qualified to say whether you love the idea of taking a flier or whether you prefer to play it safe.
The next consideration is your age, specifically how many years you are from retirement. The basic rule of thumb is that a younger person can invest a greater percentage in riskier stock funds. At best, the funds could pay off big. At worst, there is time to recoup losses since retirement is not imminent.
The same person should gradually reduce holdings in risky funds, moving to safe havens as retirement approaches. In the ideal scenario, the older investor has stashed those big early gains in a safe place while still adding money for the future.
Traditional guidance is that the percentage of your money invested in stocks should equal 100 minus your age. More recently, that figure has been revised to 110 or even 120 because the average life expectancy has increased. Using a basis of 120, a 30-year-old would invest 90% of their portfolio in equities, while a 70-year-old would invest 50%.
If you need further incentive, it might help to know that experts set 10% of your current income as a rule of thumb for how much you should set aside for retirement. They also suggest as much as 15% is needed to get on track if you've been contributing less or need to bounce back from setbacks, such as the 2008 recession.
How Much You Need
As a general rule of thumb, many financial advisors recommend having enough saved in retirement funds plus other sources of income, such as social security or a pension, to replace 80% of your income before retirement. If you have determined how much you will receive from other sources of income, you can use a conservative estimate of roughly 5–6% in annual returns from your 401(k) to figure out what sort of balance you will need to generate the additional income to achieve 80%.
Another quick and simple way to estimate the amount you will need to have saved is to take your pre-retirement income and multiply it by 12. So, for example, if you were making $50,000 a year and were considering retirement, you should have about $600,000 saved in your 401(k).
A more comprehensive approach would be to use a "retirement calculator." Many financial institutions that manage 401(k) plans offer online, interactive retirement calculator tools that will allow you to use different assumptions and automatically calculate the required savings amount needed to achieve your goals. They typically also have knowledgeable representatives that will walk you through the process. You should take advantage of these resources if they are available, assuming you don't already have a financial advisor.
Decisions About Diversification
You probably already know that spreading your 401(k) account balance across various investment types makes good sense. Diversification helps you capture returns from a mix of investments—stocks, bonds, commodities, and others—while protecting your balance against the risk of a downturn in any one asset class.
Your decisions start with picking an asset-allocation approach you can live with during up and down markets. After that, it's a matter of fighting the temptation to time the market, trade too often or think you can outsmart the markets. Review your asset allocations periodically, perhaps annually, but try not to micromanage.
Some experts advise saying no to company stock, which concentrates your 401(k) portfolio too narrowly and increases the risk that a bearish run on the shares could wipe out a big chunk of your savings.
Vesting restrictions may also prevent you from holding on to the shares if you leave or change jobs, making you unable to control the timing of your investments. If you're bullish on your company and feel you want to invest in its stock, the general rule of thumb is to have no more than 10% of your portfolio made up of company stock.
Target-date funds can be a good set-it-and-forget-it option for retirement accounts. These funds offer diversified portfolios that automatically become more conservative over time as retirement approaches.
Avoid Choosing Funds With High Fees
It costs money to run a 401(k) plan. The fees generally come out of your investment returns. Consider the following example posted by the Department of Labor.
Say you start with a 401(k) balance of $25,000 that generates a 7% average annual return over the next 35 years. If you pay 0.5% in annual fees and expenses, your account will grow to $227,000. However, increase the fees and expenses to 1.5%, and you'll end up with only $163,000—effectively handing over an additional $64,000 to pay administrators and investment companies.
It's important to be aware that you can't avoid all the fees and costs associated with your 401(k) plan. They are determined by the deal your employer made with the financial services company that manages the plan.
What to Look for
Among your choices, avoid funds that charge the biggest management fees and sales charges. Actively managed funds are those that hire analysts to conduct securities research. This research is expensive and drives up management fees.
Index funds generally have the lowest fees because they require little or no hands-on management by a professional. These funds are automatically invested in shares of the companies that make up a stock index, like the S&P 500 or the Russell 2000, and change only when those indexes change. If you opt for well-run index funds, you should look to pay no more than 0.25% in annual fees. By comparison, a relatively frugal actively-managed fund could charge you 1% a year.
How Much Should I Invest?
If you are many years from retirement and struggling with the here and now, you may think a 401(k) plan isn't a priority. However, the combination of an employer match (if the company offers it) and a tax benefit should make it irresistible—the employer's match is tax-deferred money invested for you.
When starting out, the achievable goal might be a minimum contribution to your 401(k) plan. That minimum should be the amount that qualifies you for the entire match from your employer. You also need to contribute the maximum yearly contribution to get the full tax savings.
The number of Americans who actively participate in a 401(k) plan as of September 2021.
The amount employers contribute varies from company to company. Some match 50% for each dollar put in by the employee, and the company may put a limit on their contribution amount. In addition, if you contribute to a traditional 401(k) plan, you are effectively reducing your federal taxable income by the amount you contribute to the plan.
As retirement approaches, you may be able to start stashing away a greater percentage of your income. Granted, the time horizon isn't as distant, but the dollar amount is probably far larger than in your earlier years, given inflation and salary growth. Taxpayers can contribute up to $22,500 for 2023 (up from $20,500 in 2022), while people aged 50 and over can contribute an additional $7,500 yearly.
Extra Benefits for Lower-Income Savers
The federal government offers another benefit to lower-income people. Called the Saver's Tax Credit, it can raise your refund or reduce the taxes owed by offsetting a percentage (up to 50%) of the first $2,000 ($4,000 if married filing jointly) that you contribute to your 401(k), IRA, or similar tax-advantaged retirement plan.
This offset is in addition to the usual tax benefits of these plans. The percentage depends on the taxpayer's adjusted gross income for the year and tax-filing status. The income limits to qualify for the minimum percentage offset under the Saver's Tax Credit are as follows:
- For single taxpayers (or a married person filing separately), the income limit is $36,500 (up from $34,000 in 2022).
- For married couples filing jointly, it's $73,000 (up from $68,000 in 2022).
- For heads of household, it maxes out at $54,750 (up from $51,000 in 2022).
After Establishing the Plan
Once your portfolio is in place, monitor its performance. Keep in mind that various stock market sectors do not always move in lockstep. For example, if your portfolio contains both large-cap and small-cap stocks, the small-cap portion of the portfolio will likely grow more quickly than the large-cap portion. If this occurs, it may be time to rebalance your portfolio by selling some of your small-cap holdings and reinvesting the proceeds in large-cap stocks.
While it may seem counterintuitive to sell the best-performing asset in your portfolio and replace it with an asset that has not performed as well, keep in mind that your goal is to maintain your chosen asset allocation. When one portion of your portfolio grows more rapidly than another, your asset allocation is skewed toward the best-performing asset. If nothing about your financial goals has changed, rebalancing to maintain your desired asset allocation is a sound investment strategy.
Try not to borrow from your plan. Borrowing against 401(k) assets can be tempting if times get tight. However, doing this effectively nullifies the tax benefits of investing in a defined-benefit plan since you'll have to repay the loan in after-tax dollars. On top of that, you will be assessed interest and possibly fees on the loan. Plus, you will often be unable to make 401(k) contributions until the loan has been paid off.
Take Your 401(k) With You
Most people will change jobs more than half-a-dozen times throughout a lifetime. Some of them may cash out of their 401(k) plans every time they move, which can be costly. If you cash out every time, you will have nothing left when you need it—especially given that you'll pay taxes on the funds, plus a 10% early withdrawal penalty if you're under 59½. Even if your balance is too low to keep in the plan, you can roll that money over to an IRA and let it keep growing.
If you're moving to a new job, you may also be able to roll over the money from your old 401(k) to your new employer's plan if the company permits this. Whichever choice you make, be sure to make a direct transfer from your 401(k) to the IRA or to the new company's 401(k) to avoid risking tax penalties.
How Much Should I Contribute to My 401(k)?
As long as you can afford to do so, it's often advised that you contribute enough to your 401(k) to at least maximize your employer's contribution.
How Do I Start a 401(k)?
If you work for a company that offers a 401(k) plan, contact the human resources or payroll specialist responsible for employee benefits. You'll likely be asked to create a brokerage account through the brokerage firm your employee has selected to manage your funds. During the setup process, you'll get to choose how much you want to invest and which types of investments you want your 401(k) funds invested in.
What Are the Benefits of a 401(k)?
There are two main benefits to a 401(k). First, companies usually match at least a portion of the money you put into your 401(k). Second, these accounts come with tax benefits. You don't have to pay taxes on the money you contribute or on the gains you earn over time if your contributions are pre-tax and made to a traditional 401(k), but you'll have to pay regular income tax on the withdrawals when it comes time to take the money out in retirement. You don't get to deduct your contributions on your federal income tax return if your contributions are post-tax and made to a Roth 401(k), but your gains over time aren't taxed, nor are your withdrawals in retirement.
Can You Lose Money in a 401(k)?
Yes. Because your 401(k) will be invested in various assets (e.g., stocks, bonds, etc.), your portfolio will be exposed to market risk. If the stock market crashes, the stock component of your portfolio will also go down in value.
The Bottom Line
Building a better runway to retirement or financial independence starts with saving. The "pay yourself first" method works best, which is why your employer's 401(k) plan is a good place to place cash.
Once you get past the endless prose of the financial company's literature, you may find yourself genuinely interested in the wide variety of investing that a 401(k) plan opens to you. In any case, you'll enjoy watching your nest egg grow from quarter to quarter.