If your employer offers a 401(k) plan, you may have wondered if it’s really where you want 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?
The average rate of return on 401(k)s from 2015 to 2020 was 9.5%, according to data from retirement and financial service provider, Mid Atlantic Capital Group.
Keep in mind, returns will vary depending on the individual investor’s portfolio, and 9.5% is a general benchmark.
Here’s what you should know to help you make an informed decision.
Some 401(k) Basics
To understand what a 401(k) has to offer, it helps to know exactly 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 set up through their employer. Because participants put the money from their paychecks into their 401(k) account on a pre-tax basis, those contributions reduce their annual taxable income.
Taxes on the contributions and their growth in a 401(k) account are deferred until the money is withdrawn (unless it’s an after-tax Roth 401(k)).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 regular contributions made to the plan and by the performance of the investments the participant chooses.
This is different from a “defined-benefit” plan, or pension. A defined-benefit plan guarantees the employee a defined monthly income in retirement, putting any investment risk on the plan provider rather than the employee.
Benefits of a 401(k)
There are a lot of benefits that come with a 401(k) account, and some good reasons to consider using one to save for retirement.
Potential Employer Match
Employers aren’t required to make contributions to employee 401(k) plans, but many do. Typically, an employer might offer to match a certain percentage of an employee’s contributions.
As we mentioned, most 401(k)s are tax-deferred. This means that the full amount of the contributions can be invested until you’re ready to withdraw funds. And you may be in a lower tax bracket when you do start withdrawing and have to pay taxes on your withdrawals.
Employer-sponsored 401(k)s plans encourage saving for the long-term and starting early. That allows for compound interest, which means that you earn interest not only on the funds put in your account, but on the interest those funds earn, which means you can potentially accumulate more money over time. Compound growth over time can be one of an investor’s most valuable tools.
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 any employers that 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. Those include the 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.
401(k) Fees, Vesting, and Penalties
But there can be some downsides for some 401(k) investors, as well. It’s a good idea to be aware of them before you decide whether to open an account.
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 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 or your employer’s HR department, or you can do your own research on various 401(k) plans.
Although any contributions you make belong to you 100% from the get-go, that may not be true for your employer’s contributions. In some cases, a vesting schedule may dictate the degree of ownership you have of the money your employer puts in your account.
Early Withdrawal Penalties
Don’t forget, when you start withdrawing retirement funds, some of the money in your tax-deferred retirement account will finally go toward taxes. That means it’s in Uncle Sam’s interest to keep your 401(k) savings growing.
So if you decide to take money out of a 401(k) account before you’re 59½, in addition to any other taxes due when there’s a withdrawal, you’ll usually have to pay a 10% penalty. (Although there are some exceptions.) And at age 72 (or 70½, if you turned that age before Jan. 1, 2020), you’re required to take minimum distributions from your tax-deferred retirement accounts.
Potentially Limited Investment Options
One more thing to consider when you think about signing up for a 401(k) is what kind of investing you’d like to do. 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 that minimum, but they stick mostly to mutual funds. That’s meant to streamline the decision-making. But if you’re looking to diversify outside the basic asset classes, it can be limiting.
How Do 401(k) Returns Hold Up?
Life might be easier if we could know the average rate of return to expect from a 401(k). But the unsatisfying answer is, it depends.
Several factors contribute to overall performance, including the investments your particular plan offers you to choose from and the individual portfolio you create. And of course, it also depends on what the market is doing from day to day and year to year.
Despite the many variables, you may often hear an annual return that ranges from 5 to 8% cited as what you can expect. But that doesn’t mean an investor will always be in that range. Sometimes you may have double-digit returns. Sometimes your return might drop down to negative numbers.
In fact, the Employee Benefit Research Institute found that between 2010 and 2018, 401(k) accounts experienced a compound annual average growth rate of 13.9%.
Some Common Approaches to 401(k) Investing
There are many different ways to manage your 401(k) account, and none of them comes with a guaranteed return. But here are a few popular strategies.
60/40 Asset Allocation
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%.
One technique sometimes used to try to maintain balance in a portfolio as the market fluctuates is a basic 60/40 mix. That means the account allocates 60% to equities (stock) and 40% to bonds. The intention is to minimize risk while generating a consistent rate of return over time—even when the market is experiencing periods of volatility.
The return for a traditional 60/40 mix of large-cap stocks and US Treasury bonds over the past 10 years has been described as about 10%.
As a retirement plan participant, you can figure out your preferred mix of investments on your 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 you expect to retire.
A 2050 target-date fund will likely be more aggressive. It might have more stocks than bonds, and it will typically have a higher rate of return. A 2025 target-date fund will lean more toward safety. It will likely be designed to protect an investor who’s nearer to retirement, so it might be invested mostly in bonds. (Again, the actual returns an investor will see may be affected by the whims of the market.)
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 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.
Multiple Retirement Accounts
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. You could try 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.
Ways to Make the Most of Investment Options
It’s up to you to manage your employer-sponsored 401(k) in a way that makes good use of the choices. Here are some pointers.
Understand the Match
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 your job before you’re fully vested.
Consider Your Investments
With or without help, taking a little time to assess the investments in your plan could boost your bottom line. It may also allow you 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.
Plan for Your Whole Life
If you have a career plan (will you stay with this employer for years or be out the door in two?) and/or a personal plan (do you want to buy a house, have kids, start your own business?), factor those into your investment plans. Doing so may help you decide how much to invest and where to invest it.
Find Your Lost 401(k)s
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 separate from your workplace account. You might also want to review and update your portfolio mix, and you might be able to eliminate some fees.
Know the Maximum Contributions for Retirement Accounts
Keep in mind that there are different contribution limits for 401(k)s and IRAs . For those under age 50, the 2021 contribution limit is $19,500 for 401(k)s and $6,000 for IRAs. For those 50 or older, the 2021 contribution limit is $26,000 for 401(k)s and $7,000 for IRAs. Other rules and restrictions may also apply.
Learn How to Calculate Your 401(k) Rate of Return
This information can be useful as you assess your retirement saving strategy, and the mat isn’t difficult.
For this calculation, you’ll need to figure out your total contributions and your total gains for a specific period of time (let’s say a calendar year).
You can find your contributions on your 401(k) statements or your pay stunts. Add up the total for the year.
Your gains may be listed on your 401(k) statements as well. If not, you can take the ending balance of your account for the year and subtract the total of your contributions and the account balance at the beginning of the year. That will give you your total gains.
Once you have those factors, divide your gains by your ending balance and multiply by 100 to get your rate of return.
Here’s an example. Let’s say you have a beginning balance of $10,000. Your total contributions for the year are $6,000. Your ending balance is $17,600. So your gains equal $1,600. To get your rate of return, the calculation is:
(Gains / ending balance) X 100 =
($1,600 / $17,600) X 100 = 9%
While your annual return on your 401(k) may vary, the good news is that, as an investor, you have options about how you save for the future. The choices you make can be as aggressive or as conservative as you want, as you choose the investment mix that best suits your timeline and financial goals.
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