The best kind of 401(k) plan is one that is used. The employer-sponsored retirement plan is typically easy to open and fund (with pre-tax dollars often deducted straight from your paycheck), and offers tax benefits vs. saving and investing in a brokerage account.
Understanding the nuances of this all-important savings vehicle may help catapult investors into full-blown expert territory, helping them maximize their 401(k) investing.
While everyone’s financial and retirement situation is different, there are some useful 401(k) investing tips that could be helpful to anyone using this popular investment plan to boost their retirement savings. These 401(k) should apply no matter what stage of retirement saving you’re in—as long as you’re participating in a 401(k).
1. Take Advantage of Your Employer Match
2. Consider Your Circumstances Before Contributing the Match
3. Understand Your 401(k) Investment Options
4. Stay the Course
5. Change Your Investments Over Time
6. Find—and Keep—Your Balance
8. Beware Early Withdrawals
#1 Take Advantage of Your Employer Match
This first 401(k) tip is admittedly basic, but also probably the most important. Understanding your employer match is essential to making the most of your 401(k).
Also called a company match, an employer match is a contribution made to your 401(k) by your employer, but only when you contribute to your account first.
One example of employer matching might be an employer matching 3% when you contribute 6%. Your employer may do something different, so be sure to find out.
Even if you don’t choose to contribute the maximum allowable amount to your 401(k), you still may want to take advantage of your match. In other words, to follow the example above, if your maximum contribution limit is 10% and you don’t plan to contribute that much, it might make sense to at least contribute 6%, so that your employer contributes an additional 3%.
An employer match is sometimes referred to as “free money,” as in, “don’t leave this free money on the table.” While that may be a playful way to think about it, an employer match is money that is part of your compensation and benefits package. It’s yours, so claiming it could be your first step in wealth building.
#2 Consider Your Circumstances Before Contributing the Max
A lot of 401(k) advice revolves around getting people to try to contribute the maximum allowed each year. And that can make sense for a lot of people, particularly if contributing the max isn’t a huge financial stretch.
But if you’re spending every last dime trying to reach that maximum contribution number, it may not be the best use of your money.
First, you may want to think about whether you’re going to need any of those funds prior to retirement. Withdrawing money early from a 401(k) can result in a hefty penalty.
There are some exceptions, depending on what you’ll use the withdrawn funds for. For example, qualified first-time home buyers may be exempt from the early distribution penalty. But for the most part, if you know you need to save for some big pre-retirement expenses, it may be better to do so in a non-qualified account.
Another consideration is whether to put all of your eggs in your 401(k) basket. Of course, these accounts can offer big benefits in terms of tax deferral and may come with a matching contribution from your employer as well. But individuals who are eligible to contribute to a Roth IRA, may consider splitting contributions between the two accounts.
While 401(k) contributions are made with pre-tax dollars and taxes are paid when you make a withdrawal, Roth IRA contributions are the opposite—taxed on the way in, but not on the way out (with some exceptions).
If you’re concerned about being in a higher tax bracket at retirement than you are now, a Roth IRA can make sense as a complement to your 401(k). The caveat is that these accounts are only available to people below a certain income level.
#3 Understand Your 401(k) Investment Options
The first step is contributing to a 401(k); the second is directing that money into particular investments. Typically, plan participants are able to choose from a list of mutual funds to invest in for the long-term. Some 401(k) plans may give participants the option of a lifecycle fund or a retirement target-date fund.
To pick the right mutual funds, you may want to consider what is being held inside those mutual funds. For example, a mutual fund that is invested in stocks means that you are now invested in the stock market.
With each option, ask yourself: Does the underlying investment make sense for your goals and risk tolerance? Are you prepared to stay the course in the event of a stock market correction?
You may also want to consider the fees charged by your mutual fund options, because any management fee will be subtracted from your potential future returns. When analyzing your options, look for what is called the expense ratio—that’s the annual management fee.
#4 Stay the Course
Many investors will have at least a part of their 401(k) money invested in the stock market, whether through mutual funds or by holding individual stocks.
If you’re not used to investing, it can be tempting to panic over small losses. This is also known as a day-trader mentality, and it is one of the worst things you can do—especially with a 401(k). Remember, investing in the stock market is generally considered for the long haul.
Getting spooked by a dip (or even a stock market crash like the one in 2008) and pulling your money out of the market is generally a poor strategy, because you are locking in what could possibly amount to be “paper” or temporary losses. The thinking goes, if you wait long enough, that stock might rebound and your loss will go away. (Though as always, past performance is no predictor of future success.)
It may help to remember that although stock market crashes are disappointing, they are a normal and natural part of the growth cycle. Remember, the goal is to be patient and let the stock market do its thing.
Some investors find it helpful to only check their 401(k) balance occasionally, rather than obsess over day-to-day fluctuations.
#5 Change Your Investments Over Time
Lots of things change as we age, and one of the most important 401(k) tips is to change your investing along with it. While some principles of retirement saving are eternal—use the employer match as much as you can, don’t trade too much, pay attention to fees—some 401(k) advice is specific to where you are relative to retirement.
While everyone’s situation is different and economic conditions can be unique, one rule of thumb is that as you get closer to retirement, it makes sense to shift the composition of your investments away from higher risk but potentially higher growth assets like stocks, and towards lower risk, lower return assets like bonds.
There are types of funds and investments that manage this change over time, like target date funds, that make this strategizing easier. Some investors choose to make these changes themselves as part of a quarterly or annual rebalancing.
#6. Find—And Keep—Your Balance
While you may want your 401(k) investments to change over time, at any given time, you should have a certain goal of how your investments should be allocated: a certain portion in bonds, stocks, international stocks, American stocks, large companies, small companies, and so on.
But these targets and goals for allocation can change over time even if your allocations and investment choices don’t change. That’s because certain investments may grow faster than others and thus, by no explicit choice of your own, they take up a bigger portion of your portfolio over time.
Rebalancing is a process where, every year or every few months, you buy and sell shares in the investments you have in order to keep your asset allocation where it was at the beginning of the year.
For example, if you have 80% of your assets in a diversified stock market fund and 20% of your assets in a diversified bond fund, over the course of a year, those allocations may end up at 83% and 17%.
To address that, you might either sell shares in the stock fund and buy shares in the bond fund in order to return to the original 80/20 mix, or adjust your allocations going forward to hit the target in the next year.
In addition to employer matching, diversification is considered one of the few “free lunches” for investors. By diversifying your investments, you can help to lower the risk of your assets tanking while still being exposed to the gains of the market.
This is especially important in 401(k) investing, which focuses on saving and investing over the very long term. There are several ways to diversify a 401(k), and one of the most important 401(k) investing tips is to recognize how diversification can work both between and within asset classes.
Diversification applies to both your overall asset allocation and the assets you allocate into. While every situation is different, typically it’s useful to be exposed to stocks and fixed-income assets, like bonds. (Here’s a deeper dive on the difference between stocks and bonds.)
Within stocks, diversification can mean investing in US stocks, international stocks, big companies, and small companies. But rather than, for example, owning shares in one big American company, one big Japanese company, a multi billion-dollar company, and a smaller company, it might make sense instead buy diversified funds in all these categories that are diversified within themselves—thus offering exposure to the whole sector without being at the risk of any given company collapsing.
#8 Beware Early Withdrawals
Perhaps the most important 401(k) tip is to remember that the 401(k) is designed for retirement, with funds withdrawn only after a certain age. The system works by letting you invest income that isn’t taxed until distribution. But if you withdraw from your 401(k) early, much of this advantage disappears.
With few exceptions, the IRS imposes a 10% tax penalty on withdrawals made before age 59½. That 10% tax is on top of any regular income taxes a plan holder would pay on 401(k) withdrawals. While withdrawals are sometimes unavoidable, the steep cost of withdrawing funds should be a strong reason not to, as it wipes away much of the gains that can come from 401(k) investing.
If you would like to buy a car or a house, or pay off debt, there are other options to explore. First consider pulling money from any accounts that don’t have an early withdrawal penalty, such as a Roth IRA (contributions can be withdrawn penalty-free as long as they’ve met the 5-taxable-year rule) or a brokerage account.
If you have a 401(k) through your employer, you may want to consider taking advantage of it. Not only might you have a company match, but automatic contributions taken directly from your paycheck and deposited into your 401(k) may keep you from forgetting to contribute.
That said, a 401(k) is not the only option for saving and investing money for the long-term. One such option is a Roth IRA. While there are income limitations to who can use a Roth IRA, these accounts also tend to have a bit more flexibility when withdrawing funds than 401(k) plans. (If you don’t qualify for a Roth IRA, ask your tax professional for additional guidance.)
Another option is to open an investment account that is not tied to an employer-sponsored retirement plan. Sometimes called a brokerage or after-tax account, these accounts don’t have the special tax treatment of retirement-specific accounts, but can still be viable ways to save money for people who have maxed out their 401(k) contributions or are looking for an alternative way to invest.
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