If your employer offers a 401(k) plan, you’ve probably wondered if it’s really the right place to put a portion of your hard-earned money every month.
You’ve likely been told that the earlier you start saving for retirement, the better off you’ll be. But how can you know that the average rate of return on your 401(k) investments will be the same or more than other available options?
After all, if you’re going to make sacrifices now to put money toward the future, you want it to be the best retirement possible.
A Few 401(k) Basics
To understand what a 401(k) has to offer, it can help to know what it is. The IRS defines a 401(k) as “a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.”
In other words, employees can choose to delegate a portion of their pay to an investment account that is set up through their employer.
And because participants put the money from their paycheck into their 401(k) on a pre-tax basis, those contributions reduce their annual taxable income.
Taxes are deferred on contributions and growth in a 401(k) account until the money is withdrawn (unless it’s an after-tax Roth 401(k)).
A 401(k) is a “defined-contribution” plan, which means the participant’s balance is determined by contributions made to the plan and the performance of the investments the participant chooses.
That makes it different from a “defined-benefit” plan, or pension, which puts the investment risk on the plan provider and guarantees the employee a monthly income in retirement.
Employers aren’t required to make contributions to employee 401(k) plans, though many do—typically by offering to match a certain percentage of an employee’s contributions.
Besides the tax advantages and the convenience of automatic 401(k) payroll deductions—which can help make saving simpler for everyone, but especially for those who might otherwise lack the discipline—it’s the employer match that can be a big draw for plan participants. It’s tough to turn down free money.
Employer-sponsored 401(k)s have made investing accessible to more Americans, and the plans encourage saving for the long-term. Compound growth over time can be one of an investor’s most valuable tools.
And the less money there is coming out of a paycheck because of taxes, the more there is available for compounding. But there are other factors to consider when looking at a 401(k).
One of the less-talked about benefits of 401(k) plans is that they’re protected by federal law. The Employee Retirement Security Act of 1974 (ERISA) sets minimum standards for employers that choose to set up retirement plans and for the administrators who manage them.
Those protections include a claims and appeals process to make sure employees get the benefits they have coming—that there is a right to sue for benefits and breaches of fiduciary duty if the plan is mismanaged, that certain benefits are paid if the participant becomes unemployed, and that plan features and funding are properly disclosed. Another plus: ERISA-qualified accounts are protected from creditors.
401k Fees, Vesting and Penalties
But there are some downsides for some 401(k) investors. The typical 401(k) plan charges a fee of 1% of assets under management. That means an investor who has $100,000 in a 401(k) could pay $1,000 or more. And as that participant’s savings grow over the years, the fees could add up to thousands of dollars.
Fees eat into your returns and make saving harder—and there are companies, including SoFi Invest®, that don’t charge management fees on their investment accounts. (If you’re unsure about what you’re paying, you should be able to find out from your plan provider, HR, or you can do your own research on various 401(k) plans.)
Although any contributions a participant makes belong to that individual 100% from the get-go, a vesting schedule may dictate the degree of ownership the employee has when it comes to employer contributions.
And don’t forget, some of the money in that tax-deferred retirement account also belongs to Uncle Sam. And he wants 401(k) investors to keep growing their savings for retirement.
So besides any other taxes due when there’s a withdrawal, if a participant decides to take money from a 401(k) before reaching age 59½, there’s usually a 10% penalty. (Although there are some exceptions.) And at age 70½, retirees are required to take minimum distributions from their tax-deferred retirement accounts.
Another thing to consider when looking at signing up for a 401(k) is what kind of investing you’d like to do. A lot of 401(k) plans have a slim selection of investments to choose from.
Employers are required to offer at least three basic options: a stock investment option, a bond option, and cash or stable value option.
Many offer more than the minimum, but they stick mostly to mutual funds. That’s meant to streamline the decision-making for investors who might be overwhelmed by too many choices and suffer from analysis paralysis. But for those looking to diversify outside the basic asset classes, it can be limiting.
How Do 401(k) Returns Hold Up?
It would be nice if we could know the average rate of return to expect from a 401(k). But the answer is, it depends. It depends on the investments a particular plan has to choose from and the portfolio a particular participant creates. And it depends on what the market decides to do from day to day and year to year.
But that doesn’t mean a 60/40 investor will always be in that range. Sometimes that mix will have double-digit returns. Sometimes, it will drop down to negative numbers.
And no one can know how the strategy will fare as the market expands and evolves. (A financial professional may be able to help you analyze how your particular portfolio choices would have done during down markets, like those we experienced in 2000 and 2008.)
A basic 60/40 mix, which allocates 60% to equities and 40% to bonds/cash investments, is meant to maintain balance in a portfolio as the market fluctuates, minimizing risk while generating a consistent rate of return over time—even when the market is experiencing periods of volatility.
Stocks have the greatest potential for growth over time. Since 1926 , large stocks have returned an average of 10% per year, while long-term government bonds, which are considered more stable, have returned between 5% and 6%.
The 60/40 mix was popularized by Jack Bogle, the late founder of The Vanguard Group who is credited with creating the first index fund. And it’s easy to accomplish with the mutual funds available through 401(k) plans. But not every investor has to—or should—go with that exact ratio.
Asset allocation is usually based on an investor’s risk tolerance and time horizon—the amount of time until an individual will be ready to tap his or her retirement funds.
Retirement plan participants can figure out their best mix on their own, with the help of a financial advisor, or by opting for a target-date fund—a mutual fund that bases asset allocations on when the participant expects to retire.
A 2050 target-date fund will likely be more aggressive—it might have more stocks than bonds and will typically have a higher rate of return. A 2025 fund will lean more toward safety, protecting an investor who is nearer to retirement, and might be invested mostly in bonds. (Again, the actual returns an investor will see may be affected by the whims of the market.
But this is how these funds are targeted.) Most 401(k) plans offer target-date funds, and they make investing easy for hands-off investors. But if that’s not what you’re looking for, and your 401(k) plan makes an advisor available to work with you, you may be able to get more specific advice. Or, if you want more help, you could hire a financial professional to work with you on your overall plan as it relates to your long- and short-term goals.
Another possibility might be to go with the basic choices in your workplace 401(k), but also open a separate investing account with which you could take a more hands-on approach—maybe a traditional IRA if you’re still looking for tax advantages, a Roth IRA if you want to limit your tax burden in retirement, or an account that lets you invest in what you love, one stock at a time.
Making the Most of Investment Options
Whether it’s your only retirement account or not, it’s up to you to manage your employer-sponsored 401(k) in a way that makes the most of the options it offers.
One way to start is by familiarizing yourself with the rules on how to maximize the company match. Is it a dollar-for-dollar match up to a certain percentage of your salary, a 50% match, or some other calculation? It also helps to know the policy regarding vesting and what happens to those matching contributions if you leave before you’re fully vested.
With or without help, taking a little time to assess the investments in your plan could boost your bottom line, and you may be able to tailor your portfolio to better accomplish your financial goals. Checking past returns can provide some information when choosing investments and strategies, but looking to the future also can be useful.
If you have a career plan (will you stay with this employer for years or be out the door in two?) and a personal plan (do you want to buy a house, have kids, start your own business?), it may help you decide how much to invest and where to invest it.
Have you lost track of the 401(k)s you left behind at past employers? It may make sense to roll them into your current employer’s plan, or to roll them into a separate IRA outside of your workplace. You might need to update your portfolio mix, and you might be able to eliminate some fees.
Keep in mind that there are different contribution limits for 401(k)s and IRAs . For those under age 50, the 2020 contribution limit is $19,500 for 401(k)s and $6,000 for IRAs. For those 50 or older, the 2020 contribution limit is $26,000 for 401(k)s and $6,500 for IRAs. Other rules and restrictions may also apply.
The good news here is that investors have options as they save for the future. They can be as aggressive or as conservative as they want by choosing the investment mix that best suits their timeline and financial goals.
They can stick with one type of retirement account or fund, or they can diversify their investments and strategies with multiple accounts. And they can be hands-off or hands-on. The only thing they can’t afford to do is nothing.
If you have questions about how 401(k)s and other investment plans can benefit you as you work toward your goals, it can help to get some professional guidance.
With a SoFi Invest account, you’ll have complimentary access to financial advisors who can talk to you about diversifying your portfolio and maximizing the money you have to invest now and in the future.
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