Picture this: You get your first real job. You’re adulting. You’re excited to get out there and get to work. Then you get the piles of paperwork.
One of those piles is probably tied to the employer’s 401(k) plan. Most of the people I talk to know vaguely what 401(k)s are, but aren’t sure what to do when they find themselves with that paperwork.
401(k)s are employer-sponsored investment accounts designed to help you save for retirement. They are tax-advantaged, so you don’t pay income tax on the money you contribute, and your investments grow tax-free. You’ll pay income taxes when you withdraw the money in retirement.
With that in mind, here are six things that can help you get a handle on this incredibly important tool.
1. You may be automatically enrolled.
Over the past 15 years or so, employers have started automatically enrolling their employees into retirement plans. If you don’t want to invest in a 401(k) plan, you’d need to opt out of the contributions.
Employers do this because research shows that it increases participation. If this is the case where you work, you definitely need to review how much of your salary you’re set to contribute and what you’re investing your money in. If you aren’t automatically enrolled, take the time to enroll yourself.
When it comes to how much you should contribute, look at whether your employer offers a match. Some companies will match your retirement contributions up to a certain amount. This is basically free money on top of your salary, so try to take advantage of it if you can.
2. 401(k)s are usually self-directed
Most employer-sponsored plans are self-directed, which means you select what you invest in. However, you can only choose from a predetermined number of investments. These are chosen by the employer when they set up the plan.
The investment choices tend to be mutual or exchange-traded funds that spread your money out over a wide variety of investments. Think of it as a system designed to keep your eggs in a variety of baskets.
These funds tend to have cheaper fees than the same funds on the open market. You might also be surprised at the variety. Sometimes, there are as many as a hundred funds.
3. How to choose investments
When choosing from the various investments offered in a 401(k) plan, look at three things:
- What’s in it. This can help you assess how risky a fund is. For example, international stocks (or equities) tend to carry more risk than large U.S. companies (commonly referred to as large caps). Bonds, particularly U.S. treasuries, tend to be the “safest” investment.
- Previous returns. While past performance doesn’t predict future results, you can get a sense of what you might expect. In particular, take note of big swings (up 17 percent one year and down seven percent the next, for example). This can indicate volatility, which may not be right for every investor.
- Fees. There can be various fees associated with retirement accounts and the funds in them. These fees can eat into your returns, so be wary of high charges. In general, 0.5-1 percent is considered low. Check higher fees against fund performance to determine if they may be worth the charge.
If we’re working together on your 401(k), I’ll help you select which funds work best for your situation and goals, and we’ll talk about what’s in the fund. It’s important for you to understand what you’re invested in. If you want to do this on your own, you can look up the fund’s prospectus.
4. Avoid target date funds if you can
Target-date funds are one of the most common 401(k) investments, and many people opt into them by default. These funds create a target date for retirement and choose investments based on that assumption.
So if you turn 65 in 2060, you might select a 2060 target date fund. In 2020, with retirement 40 years away, the fund is focused on growth investments like stocks. As you get closer to the target retirement date, the fund will shift to bonds or other investments intended to help preserve capital.
While that sounds great in theory, a word of caution: Many of these funds are risk averse. That means a 2060 target date might have a 30 percent allocation in bonds as early as 2020, which might cause you to miss out on potential growth opportunities.
I’d recommend you avoid opting into target date funds, and instead put in the extra time to select funds that are more appropriate to your goals. I can help with this.
5. Stay on top of rebalancing
Investments grow at different rates, so it’s possible for your account to become out of balance, to the point that it no longer reflects your risk tolerance or goals.
- For example, you set up your account to have 60 percent of your money in stocks and 40 percent in bonds.
- Assume that one year later, stocks have grown at a rate of 10 percent, and bonds have returned 2 percent.
- Without rebalancing, you’d end up with more than 60 percent invested in stocks (how much more would depend on the amount you had invested).
- If you still want to have 60 percent of your money in stocks and 40 percent in bonds, you’d need to rebalance: sell some stocks and use that money to invest in bonds.
I recommend rebalancing once per year. Generally, you can do this by simply logging in to your plan portal and updating your allocations (in the above example, you’d simply reset them to 60-40). Your plan may also offer the option to rebalance automatically.
6. Read your quarterly statements
Your 401(k) provider — meaning the financial institution that manages the plan for your employer — is legally required to send you statements every quarter. Take a moment to read them, or better yet, we can go over them together.
These statements can help you get a better sense of your investments and your money over time. Reading through them each quarter can help you envision the retirement you’re planning, and help you stay on top of your goals.
As always, if you have any questions about your own 401(k) or want to discuss working together on retirement planning, let’s set up a meeting.