If you are among the millions of Americans who contributes to a 401(k) plan, you get a quarterly account statement that is a positive miracle of deadly dull prose wrapped around incomprehensible euphemisms. Worse, when you first sign up, and every year after that, you are asked to make or confirm a major financial decision based on the same dreck.
Allow us to translate. You may find it helps to make your initial investment choices and revise them when you should. To maximize your 401(k) you'll need to understand the types of investments offered, which are best suited for you and how to manage the account going forward, among other strategies.
- 401(k) plans typically offer a lineup of mutual funds that range from conservative to aggressive.
- Before choosing investments consider your risk tolerance, age, and the amount you’ll need to retire.
- Avoid choosing funds with high fees.
- Be sure to diversify your investments to mitigate risk.
- At a minimum, contribute enough to maximize an employer’s match.
- Once you have established a portfolio, monitor its performance and rebalance when necessary.
Fund Types Offered in 401(k)s
Mutual funds are the most common investment options offered in 401(k) plans, although some are starting to offer exchange-traded funds (ETFs) too. Like spicy sauces, mutual funds have standard warning labels, but instead of mild, medium and flammable, the range goes 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.
A conservative fund avoids risk, sticking with high-quality bonds and other safe investments. Your money will grow slowly and predictably, and you can’t lose the money you put in, short of a global catastrophe.
A value fund is in the middle of the risk range and invests mostly in solid, stable companies that are undervalued. These undervalued corporations usually pay dividends but are expected to grow only modestly.
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 but may find the next Enron instead. You could get rich fast or poor faster. In fact, over time the fund may swing wildly between big gains and big losses.
In between all of the above are infinite variations. Many of these may be specialized funds, investing in emerging markets, new technologies, utilities, or pharmaceuticals.
Based on your expected retirement date, you may choose a target-date fund that is intended to maximize your investment around that time. It’s not a bad idea. As the fund nears its target-date time frame investments move toward the conservative end of the investment spectrum. Watch out for fees with these funds, however; some are higher than average.
What to Consider Before Investing
You don’t have to pick just one fund. In fact, you should spread your money around several funds. How you divvy up your money—or, as the experts say, determine your asset allocation—is your decision. However, there are some things you should consider before you invest.
The first consideration is a highly personal one, and that is your so-called risk tolerance. Only you are qualified to say whether you love or hate the idea of taking a flier, or whether you prefer to play it safe.
The next big one 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 far ahead.
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.
Retirement Sum Needed
The traditional rule was 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 average life expectancies have increased.
Generally speaking, 120 minus your age is slightly more accurate given how much longer people are living these days, says Mark Hebner, author of Index Funds: The 12-Step Recovery Program for Active Investors and founder and president of Index Fund Advisors, Inc., in Irvine, California.
Nonetheless, Hebner doesn't recommend relying solely on this methodology. He suggests using a risk capacity survey to assess the proper ratio of stocks to bonds for investors.
If you need further incentive, it might help to know that experts set 10% of 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.
Decisions About Diversification
You probably already know that spreading your 401(k) account balance across a variety of 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.
Risk reduction is particularly important when you consider that a 50% loss in a given investment requires a 100% return on the remaining assets just to get back to break-even status in your account.
Your decisions start with picking an asset-allocation approach you can live with during up and down markets, says Stuart Armstrong, a Boston financial planner with Centinel Financial Group. After that, it’s a matter of fighting the temptation to market time, 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.
Avoid Choosing Funds With High Fees
It costs money to run a 401(k) plan—a hefty tab that generally comes 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.
You can’t avoid all of 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. This Department of Labor explains the details of typical fees and charges.
Basically, the business of running your 401(k) generates two sets of bills—plan expenses, which you cannot avoid, and fund fees, which hinge on the investments you choose. The former pays for the administrative work of tending to the retirement plan itself, including keeping track of contributions and participants. The latter includes everything from trading commissions to paying portfolio managers' salaries to pull the levers and make decisions.
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 it drives up management fees, says James B. Twining, CFP®, CEO and founder, Financial Plan, Inc., in Bellingham, Washington.
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 Index or the Russell 2000 Index, 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, says Morningstar editor Adam Zoll. 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 just isn’t a priority. But the combination of an employer match (if the company offers it) and a tax benefit make it irresistible.
When you’re just starting out, the achievable goal might be a minimum payment to your 401(k) plan. That minimum should be the amount that qualifies you for the full match from your employer. To get the full tax savings, you need to contribute the yearly maximum contribution (see below).
The number of Americans who participate in a 401(k) plan, according to the Investment Company Institute.
These days, it’s common for employers to contribute a little less than 50 cents for each dollar paid in by the employee, up to 6% of salary. That’s a salary bonus of nearly 3%. In addition, 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. This strategy also is enshrined in the federal tax code. In 2019, taxpayers under age 50 can contribute up to $19,000 of pretax income, while people age 50 and over can contribute an additional $6,000.
In addition, as you near retirement, this is a good time to try to reduce your marginal tax rate by contributing to your company’s 401(k) plan. When you retire, your tax rate may drop, allowing you to withdraw these funds at a lower tax rate, says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Massachusetts.
Extra Benefits for Lower-Income Savers
The federal government is so hot to promote retirement savings that it offers another benefit for people who have lower incomes, and it’s not all that low. Called the Saver’s Tax Credit, it can raise your refund or reduce the tax you owe by offsetting a percentage (up to 50%) of the first $2,000 ($4,000 if married filing jointly) that you put into your 401(k), IRA, or similar tax-advantaged retirement plan. This offset is in addition to the usual tax benefits of these plans. The size of the percentage depends on the taxpayer's adjusted gross income for the year.
In 2019, eligibility for this credit ranges from:
- $19,250 to $32,000 for singles or married people filing separately
- $28,875 to $48,00 for heads of households
- $38,850 to $64,000 for married couples filing jointly
After Establishing the Plan
Once your portfolio is in place, monitor its performance. Keep in mind that various sectors of the stock market do not always move in lockstep. For example, if your portfolio contains both large-cap and small-cap stocks, it is very likely that the small-cap portion of the portfolio will 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 in favor of the best performing asset. If nothing about your financial goals has changed, rebalancing to maintain your desired asset allocation is a sound investment strategy.
And keep your hands off it. 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 may be assessed fees on the loan.
Resist the option, says Armstrong. The need to borrow from your 401(k) is typically a sign that you need to do a better job of planning out a cash reserve, saving, or cutting spending and budgeting for life goals.
Some argue that paying yourself back with interest is a good way to build your portfolio, but a far better strategy is not to interrupt the progress of your long-term savings vehicle's growth in the first place.
Take Your 401(k) With You
Most people will change jobs more than half-a-dozen times over the course of a lifetime. Far too many of them will cash out of their 401(k) plans every time they move. This is a bad strategy. 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 new company's 401(k) to avoid risking tax penalties.
The Bottom Line
Building a better runway to retirement or to financial independence starts with saving. The "pay yourself first" method works best, and that’s one reason why your employer 401(k) plan is such a good place to stash cash, says Charlotte Dougherty, CFP®, founder of Dougherty & Associates in Cincinnati, Ohio.
Once you get past the deathless prose of the financial company’s literature, you may find yourself truly interested in the many varieties 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.