A 401(k) plan is a type of employer-sponsored retirement investment plan that offers tax advantages. Each time you receive a paycheck from your employer, you have the option to put a small percentage into your 401(k) account. You can divert these funds into any one of the investments your company offers. Most employers also provide a match program you can use to save even more.
We’ll take a closer look at how you can maximize your 401(k) contributions. Get ready for a better retirement!
Investment Options for a 401(k)
One of your first questions might be, “What should I invest in?” There isn’t a simple way to answer this question because the assets you’ll have access to will vary depending on what your employer has chosen to offer. At the legal minimum, your employer must offer at least 3 investment options for your 401(k) plan: a stock investment option, a bond investment option and a stable cash investment option. However, most employers go above and beyond and offer a wide range of fund choices.
Here are a few of the most common assets you might see available when you invest in your 401(k):
- S&P 500 index fund: The S&P 500 is a stock market index that tracks the performance of the 500 largest companies trading on the American stock exchange. When you invest in an S&P 500 index fund, you invest in a weighted set of the companies that make up the bulk of the American economy. S&P 500 index funds are a safe choice for most investors.
- Target date retirement funds: Target date retirement funds are an excellent choice for investors who know when they want to retire. As their name implies, target date retirement funds invest in a mix of stocks and bonds that are appropriate depending on your age. These funds reallocate assets automatically as you grow older and get closer to retirement.
For example, let’s say that you plan to retire in the year 2055. Your employer might offer a fund called “Retirement Target 2055” that you could invest in. During the beginning of your career, this fund would likely invest heavily in assets with the most growth potential — like stocks. As you near retirement, the fund will automatically sell off riskier assets and buy safer assets (like bonds) to ensure you can retire on schedule. Target date funds are a popular “set it and forget it” choice for investors because they automatically readjust without input from you.
- Bond market index fund: A bond index fund tracks the bond market of the United States. These funds include both corporate and government bonds and are usually the most secure asset in any portfolio besides cash. This is because, unlike stocks, the value of each bond is guaranteed by the entity issuing the bond. Bonds are an excellent choice for older investors nearing retirement age.
- Money market funds: You can also hold cash in your 401(k) through a money market fund. Money market funds hold liquid cash in your 401(k) account. The downside is that, unlike stocks or bonds, cash is very unlikely to significantly increase in value by the time you retire.
These 4 options are just a few of the most common investment products you might see when you contribute to your 401(k). Your employer may offer only these assets or they might offer dozens of other choices. You might even see multiple stock or bond indexes available for your plan. Consult with your HR representative to learn more about each 401(k) investing option available to you.
Steps to Maximizing Your 401(k) Investments
The best way to ensure that you’re able to retire on time is to start investing in your 401(k) as soon as possible. Let’s take a look at a few investment tips for a 401(k) to maximize your savings:
- Start early. Begin investing in your 401(k) as soon as you’re able to. If you invest early, you give your money more time to grow and you earn compound interest over time. Don’t wait until you’re 30 to begin your contributions.
- Max out your employer’s match. Most employers offer 401(k) match programs that allow you to double what you contribute to your retirement account without spending more. For example, if you earn $1,000 per pay period and you elect to contribute 5% to your 401(k) each period, your employer might offer to match that 5%. This means that you’ll take home $950 (before taxes) but receive $100 in your 401(k) account — $50 from you and $50 from your employer.
- Consider a Roth 401(k). A Roth 401(k) is almost exactly the same as a traditional 401(k). However, instead of contributing money before tax, you pay tax before you put money into your account. Then, when you withdraw the money, you don’t need to pay income tax on what you take out. This can be a great choice for younger investors in a lower tax bracket now.
- Increase your savings as you grow. It can be tempting to spend that extra money when you get a raise. Don’t allow the “lifestyle creep” to set in by increasing your 401(k) contribution percentage as soon as you get a raise. Your future self will thank you.
- Avoid 401(k) withdrawals. If you encounter financial hardship, it can be tempting to withdraw money from your 401(k) plan. However, this almost always comes along with steep penalties that aren’t worth the cost. Build up a liquid emergency fund of at least $1,000 before you start investing so you won’t be tempted to touch your money later.
401(k) Investment Strategy by Age
As a general rule, you’ll want to divert most of your funds into stocks when you first begin investing. Stocks are typically the most volatile asset you can invest in through a 401(k). They have the potential to quickly increase in value if the economy is doing well — but they can also fall in value. As a younger investor, you have time to ride out these economic “rough patches” and enjoy more gains over time.
When you get closer to retirement, you’ll want to transfer your riskier assets into bonds. Bonds have backing from a corporation or the federal government and their prices are insured. Unlike stocks, bonds are unlikely to drastically change in value over time. This makes them a safer bet if you’re close to retirement and can’t risk your funds. The best strategy for a 401(k) begins with a growth-oriented portfolio and transitions to lower-risk items as you age.
Consider a target retirement fund if you don’t want to manage your own assets. These funds adjust their ratios between volatile and stable assets on your behalf.
How to Maximize Employer Contributions
If your employer offers a 401(k) match program, you should take full advantage of it. 401(k) match programs are essentially free money for you. You don’t see a withdrawal from your paycheck, yet you double the amount you save for retirement. There are no downsides to using these match programs — especially as a younger investor.
First, find out how your company’s 401(k) match program works. There are 2 common matching schedules your employer may use:
- 50% match up to a certain percentage: In this match schedule, your employer will contribute $0.50 into your 401(k) for every dollar you contribute up to a set percentage. For example, let’s say that you earn $50,000 per year and your employer offers a 50% match up to 6%. If you contribute the maximum matching amount to your 401(k) each year, you’d contribute $3,000 of your pretax income. Your employer would then put in $1,500 of their own money, giving you a total balance of $4,500.
- Dollar-for-dollar match up to a certain percentage: In this match schedule, your employer contributes $1 for every $1 you put into your 401(k) account up to a certain percentage. For example, if you earn $50,000 a year and your employer offers a dollar-to-dollar match up to 5%, maxing out your percentage leaves you with $5,000 in your account.
You’re free to contribute as much or as little of your salary as you want to your 401(k) up to the annual limit ($19,500 for 2020). However, your employer will only match up to its set percentage. If your company sets a matching limit at 5% and you contribute 10%, you’ll only receive a match for the first 5%.
Keep in mind that company match programs are employer-specific. Your employer may match more than the above percentage examples, or they might not match at all.
Your matches may also be subject to a vesting schedule. This means that you must stay with the company for a set number of years before you can permanently keep the company’s match contributions. Ask your HR representative about your company’s vesting schedule.
Should You Use a Financial Advisor for Your 401(k)?
You can also hire a financial advisor to help you manage your 401(k). A financial advisor takes a personal look at your unique financial situation and investment options and helps you manage your money according to your needs. Your financial advisor may advise you to adjust your asset ratio, buy a certain fund or put a larger percentage of your income into your 401(k).
The downside of professional financial management is the cost. Most financial advisors charge between 0.15% and 0.70% of your total assets per year for advising services. This is in addition to any fees charged by actively managed funds in your account.
What if there is a Recession?
Recession is a natural part of the economic cycle. Many investors are terrified of what will happen to their portfolio if another recession hits. However, the truth is that if you’ve stuck with a plan appropriate for your age and retirement schedule, the impact you’ll feel during the recession will be minimal in the long run. Younger investors who have time before retirement may see their portfolio drastically drop in value. However, they have time to make up for these losses when the market recovers. Older investors who have the majority of their money in stable assets (like cash and bonds) won’t see nearly as large of a drop.
The best way to “recession-proof” your 401(k) is by investing in a diverse range of assets. A diversified account balance will help minimize your losses during a recession. Above all, resist the urge to sell your assets or stop contributing during a recession. It can be tempting to attempt to “stop the bleeding” of a decreasing portfolio by selling, but you’ll lose money. Instead, contribute more money and buy when the market is low. When it inevitably recovers, you’ll see larger gains in your portfolio value.
Should You Focus on an IRA or 401(k)?
An independent retirement account (IRA) is another type of retirement account. You can have both an IRA and a 401(k). You can also transfer your 401(k) to an IRA if you decide to leave your current job.
When most people ask the question, “How can I invest in my 401(k)?” they also wonder if they should focus on an IRA instead. If your employer offers a 401(k) match program, you should focus your efforts on contributing up to your match percentage. This is free money that you can’t claim through a traditional or Roth IRA, even if you decide to rollover from an employer-sponsored account.
IRAs have much lower contribution limits than 401(k) plans. In 2020, you can contribute up to $6,000 to an IRA compared to $19,500 to a 401(k). However, if you’re a younger investor, you might want to contribute up to your 401(k)’s match limit, then open a Roth IRA. Roth IRAs use post-tax contributions to save for retirement. This means that you won’t need to pay a higher percentage when you withdraw the money in retirement. If you’re an older investor, you might want to focus on your 401(k) and open an IRA as needed for extra contributions.