401(k) Investing: Maximize Your Retirement Plan
Managing Your 401(k) for Maximum Returns
Investing in a 401(k) retirement plan is one of many popular methods that can help you build a financially secure retirement. Many investors have enjoyed long and comfortable retirements by starting to contribute early on in their employment, maximizing their employer match, and carefully managing their plans over time. Here are some tips for maximizing your 401(k) investment results.
What Is a 401(k)?
A 401(k) is a retirement investment account offered by employers to their employees. These investment accounts are designed and managed by financial services firms that are contracted by the employer. As of 2020, Charles Schwab, Bank of America, and Fidelity Investments rank the highest in group retirement plan satisfaction according to J.D. Power.
As these are accounts designed to use the power of compounding interest to earn returns, they can be built from several types of investments. You will likely see greater returns if you start investing in a 401(k) as soon as you have the opportunity because your money will have more time to grow.
Before you decide how much you should contribute and how you should diversify your 401(k) portfolio, it helps to have an understanding of your personal risk tolerance and what that means for selecting the investment options within your 401k that are right for you.
It's never too late to begin investing in a 401(k).
Assess Your Risk Tolerance
Investment risk can be loosely defined as the chance of losing money on an investment. You lose money on an asset if it loses market value. For example, if you purchased a mutual fund for $100, and it is worth $99 a year later, it has lost value. However, it might gain the dollar it lost and more back the next year.
This is investment risk, and risk tolerance is how much loss you can tolerate from an investment before you feel the need to sell it. Age plays a role in risk tolerance; if you're younger and further from retirement, you have more time to recover if an investment performs poorly. As you get closer to retirement, you'll want to take less risk with your retirement funds.
Investments are usually rated at low, medium, or high risk depending on the assets from which they are derived. They are also rated for risk by their financial performance in the past over fluctuating market circumstances.
It's important to understand your risk tolerance and learn about your 401(k) before choosing your investments.
Plan managers create 401(k) plans from different types of investments to give you options from which to choose. One of the common problems with these plans is that many people don't know how to identify which investment types or strategies are best for them or how their risk tolerance and age affect their decisions.
There are a few steps you can take as a new 401(k) investor to help you figure out your personal risk tolerance and learn more about investing in your employer's plan. Begin by completing a risk tolerance questionnaire to get a feel for your level of comfort as an investor and any age-specific concerns you may have. This will guide you in identifying a risk profile and help you find the right investments to include in your investment profile.
Then, consider taking advantage of the information sessions and educational resources provided by the financial services firm that manages your employee 401(k). You can often meet one-on-one and get personalized investment guidance. It also helps to study on your own and learn some of the terms yourself to help you become familiar with how the 401(k) works.
Ultimately, knowing your risk tolerance and a bit about the investment will help you decide how much you want to contribute and where you are comfortable allocating your money.
Start Contributing Early
Many people forgo contributing to a retirement savings plan when they begin working—early contributions form the initial earning potential for your retirement account. To make the most out of a 401(k), you should start early and do your best never to miss a contribution, even if you have to reduce the amount for a time.
If you're getting a late start, like in your 40s or 50s, there's still time to build the account. When you turn 50, you're allowed to make increased contributions to your 401(k), called catch-up contributions. You're allowed to contribute $6,500 over the annual limit of $19,500.
Maximize Employer Matching Contributions
Many large employers offer 401(k) contribution matching. Matching works exactly how it sounds—if you make contributions to your 401(k), your employer makes a matching contribution up to an absolute maximum. A general rule of thumb is contributing at least enough to your 401(k) to get the employer matching contribution.
If you're not taking advantage of employer matching, you're turning down free money and the interest that money earns.
For example, if you can't pay your rent or reduce your credit card debt because your 401(k) contributions are too high, you might be placing too much into your retirement account. However, it is important to consider that investing is as important as debt management, and if you are unable to contribute because of your debt obligations, it is important to start addressing your debt situation right away.
401(k) Investing Contribution Amount
There is no one-size-fits-all 401(k) contribution amount for everyone. The best amount to invest in a 401(k) plan is as much you can afford to contribute without hurting your other financial goals and obligations.
For example, if you can't pay your rent or reduce your credit card debt because your 401(k) contributions are too high, you might be placing too much into your retirement account. On the other hand, contributing $19,500 per year—the maximum allowed for tax year 2021 ($26,000 if you're age 50 or over)—maximizes your returns. If your employer matches your contributions, you have even more money working for you.
Many people experience several life changes within a year. You should adjust your contributions and portfolio balance whenever you experience a change that affects your finances.
Work through your finances to determine how much you can put into your 401(k) per month. The amount you come up with is called your deferral percentage. Revisiting this amount every three months is a good practice to make sure you're contributing as much as possible.
Diversify Your 401(k) Portfolio
If you have investments, you have a portfolio. A portfolio is a collection of assets that an investor has. If you have three mutual funds, three stocks, and three bonds, you have nine investments in your portfolio. It is also diversified—made up of different assets—which is generally accepted as a method of reducing the risk of investments.
There are various types of investment strategies. Choose one that is right for you.
You can use many strategies when planning your portfolio diversification—one example is the "100 minus age" technique. In this technique, the percentage of stocks in your portfolio makes up the number you get when you subtract your age from 100. The rest should be made up of mutual funds, bonds, or other investments.
An example of this technique is a 40-year-old setting up their 401(k) for the first time. Following this theory, their portfolio should be 60% stocks, with the remaining 40% in mutual funds and bonds.
Manage Your 401(k)
Once you've set up your deferral percentage and selected your investments, you can go on about your work and life and let the 401(k) do its job. However, there are a few maintenance tips you can follow.
Rebalance Your Portfolio
If the 40-year-old using the 100 minus age technique rebalances their 401(k), they will do so by reallocating the stocks into mutual funds or funds into stocks to reach the percentage required by the technique.
You shouldn't need to buy and sell from your 401(k) every time the stock market dives or climbs. Assessing your risk tolerance and balancing your portfolio from the start should keep you from needing to move money back and forth during market fluctuations.
Increase Savings Rate
When you get a raise, don't forget to give your 401(k) a raise as well. For example, if your employer offers you a promotion and a 5% raise, you might immediately increase your 401(k) deferral by at least 1%. That way, you'll still enjoy a raise, but you'll also increase your retirement savings.
Avoid Making Premature Withdrawals
Most 401(k) plans offer a hardship withdrawal option and a loan option to take money out of your plan before retirement (with certain limitations). A withdrawal could cost you a 10% early withdrawal penalty on money taken out before age 59 1/2. If you take a loan from your 401(k), you'll have to pay it back with interest by a specified time.