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Most people with some knowledge of personal finance understand the basics of stocks and bonds. They know what they are and that they’re vehicles to build wealth. But for many people, a 401(k) remains a mystery. The goal of this article is to demystify investing in your 401(k).
How Much to Invest in your 401(k)
The 401(k) is a tax-advantaged vehicle that allows you to invest dollars you earn directly from your paycheck. If you’ve paid off high-interest rate debt and have a solid emergency fund, a 401(k) is a solid place to put your savings dollars (if you haven’t, check out our article about prioritizing your investment dollars). As of 2022, up to $20,500 can be contributed to a 401(k) plan (plus catchup contributions if you’re age 50 or older).
However, many aren’t contributing that much. Why? Most people either A) don’t know how much is being contributed to their 401(k) or B) assume that the default contribution is enough. Many employers will automatically enroll you in a 401(k) plan that will take some small percentage (often ~3%) of your paycheck and contribute it to a 401(k) plan. Let’s assume that your income is $60,000. This means the automatic contribution will be a mere $1,800 per year, a far cry from the $19,500 contribution limit.
The Bare Minimum Often Equals Missing out on Free Money
And there’s another issue here: Lots of people are missing out on free money. There are very few cases in life of getting something for nothing. A 401(k) often offers something for nothing. Many employers will match the contributions an employee makes to a 401(k) plan up to a certain %.
Let’s look at an example. Let’s say an employer will match 100% of the first 3% you contribute and 50% of the next 3% you contribute. What this means is that if you contribute 6% to your 401(k), your employer will give you another 4.5%. If you are are not contributing at least 6%, in this example, you are missing out on free money from your employer. So check with your employer to find out if they match contributions and how much you need to contribute to maximize the match.
Start with three simple steps:
- Check your 401(k) contribution
- Raise your contribution to at least max out your employer match
- Aim to continue increasing 401(k) contributions up to the limit set by the government
Investing in your 401(k): Traditional vs. Roth
Traditionally, many employers offered only one type of 401(k) plan. This type of plan would allow contributions to grow tax-deferred until funds are withdrawn at retirement. However, many employers now also offer Roth 401(k) plans, in which after-tax dollars are contributed and grow tax-free in perpetuity.
One may ask, which of these offers the better deal? The answer will vary from person to person. A key question to ask is whether you think your income tax rate will be higher or lower in retirement than it is today. If you think your tax rate is lower today than it will be in the future, a Roth is a worthy option to consider, as it will allow taxes to be paid at your current income tax rate. Another benefit of the Roth 401(k) is knowing that the balance in your account is the balance you have – there is no need to worry about tax planning.
I’m Ready to Start Investing in my 401(k): How do I pick funds?
Another issue is that people will contribute to a 401(k), but often they won’t know what investments are being purchased with their money. There is typically some default investment for 401(k) contributions; this could be an index fund, a bond fund, your company’s stock, or anything in-between.
Wouldn’t you like to know where your money is going? Check and see where your investment dollars are going.
The reality is that most 401(k) plans have some good options and some bad options. The best option will ultimately depend on your financial goals, but here are a few “rules to live by”:
1. Don’t invest your 401(k) contributions in your company’s own stock.
Your income is already dependent on your employer. If your investments are also dependent on that company, it’s putting all your eggs in one basket. If the company is doing poorly and laying off people, chances are its stock isn’t performing well either. This could mean your 401(k) balance is on the decline just when you might need it the most.
When choosing funds to invest in through your 401(k), take a quick look at the fund’s expenses (most importantly, its expense ratio). If the expense ratio is 1%, for example, and on average you earn 7% per year, the fund’s expenses are eating 14% of your returns. Instead, look for funds with low costs – typically, index funds are good option. It’s not uncommon to find an expense ratio of 0.05% or less for passively managed funds.
3. Know Your Risk Profile
If you’re just getting started in life and have a long time horizon, you can afford to take a little bit more risk (think more stock, less bond). However, as you approach retirement, it’s best to get a bit more conservative (i.e. weighting more heavily towards bonds and other low-risk asset classes, even considering keeping a small portion of your portfolio in cash instruments).
Fund options in your 401(k) often offer diversification potential. For example, an S&P 500 index allows you to purchase what is effectively 500 individual stocks through one fund. Simply put, diversification reduces risk. Ways to consider diversifying include asset class (stocks, bonds, real estate, etc.), geography (domestic vs. international), market cap (big companies vs. small companies), risk within an asset class (think government bonds vs. corporate bonds, for example).
Getting Started Investing in your 401(k)
The most important thing to investing in a 401(k) is to just get started. Remember, the best way to maximize wealth is to let your dollars grow for as long as possible.
To get started in your 401(k), set your contributions with the goal to at least earn the employer match and hopefully max out your annual contribution limit. Then choose funds that offer diversification, low fees, and match your risk profile.
Are you maxing out your 401(k)? What investments are you choosing in your 401(k)? Let me know in the comments below.