Investing in a 401(k) plan is one of many popular methods that can help you build a secure retirement. Many have enjoyed long and comfortable retirements by starting to save early in their lives and maximizing their employer match.
Here are some tips for maximizing your 401(k) investment results by managing the plan over time.
What Is a 401(k)?
A 401(k) is an investment account offered by employers to their workers. These accounts are designed and managed by financial services firms that are contracted by the employer.
Charles Schwab, Bank of America, and Fidelity Investments ranked among the highest satisfaction in group retirement plans as of 2020, according to J.D. Power.
These accounts are designed to use the power of compounding returns. They can be built from many types of investments. You will likely see greater returns if you start investing in a 401(k) as soon as you have the chance. Your money will have more time to grow.
It helps to have a handle on your personal risk tolerance before you decide how much you should save to and how you should diversify your 401(k) portfolio. Know what your risk tolerance means for choosing investment options within your 401k that are right for you.
Assess Your Risk Tolerance
Risk can be defined as the chance of losing money on your investment. You lose money on an asset if it drops in market value. A mutual fund has lost value if you purchased it for $100, and it's worth $99 a year later, but in the next year it might gain back the dollar it lost and more.
Risk tolerance is how much loss you can tolerate before you feel the need to sell the investment. Your age also plays a role. You have more time to recover if an investment performs poorly if you're younger and have many years left until retirement. You'll want to take less risk as you get closer to retirement age.
Investments are rated at low, medium, or high risk, depending on the assets from which they're derived. They're also rated for risk by their past financial performance.
It's key to know your risk tolerance and to learn all you can about your 401(k) before you choose the investments that are right for you.
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 decide which types of strategies are best for them. They don't know how their risk tolerance and age can affect their choices.
You can take a few steps to figure out your personal risk tolerance. Begin by completing a risk tolerance questionnaire to get a feel for your level of comfort. Include any concerns you may have about your age, to guide you in pinning down a risk profile. It will help you find the right investments to include in your profile.
Think about taking advantage of the information sessions and educational resources provided by the financial services firm that manages your 401(k). You can often meet one-on-one and get personalized guidance. It also helps to study on your own. Learn some of the terms so you become more familiar with how a 401(k) works.
Knowing your risk tolerance and a bit about the investment will help you decide how much you want to save. It will guide you to a point where you're comfortable allocating your money.
Start Contributing Early
Many people forgo saving for retirement when they begin working, but early contributions form the initial earning potential for your account. You should start early. Do your best never to miss a contribution so you can make the most out of a 401(k), even if you have to reduce the amount you save once in a while.
There's still time to build an account if you get a late start in your 40s or 50s. You're allowed to make increased contributions to your 401(k) when you turn 50. These are called "catch-up" contributions. You can save $6,500 over the annual limit of $19,500 in 2021 and $20,500 in 2022.
Maximize Matching Contributions
Many large employers offer 401(k) contribution matching. Your employer makes a matching contribution up to an absolute maximum if you save to your 401(k). One good rule of thumb is to save at least enough to get the employer match.
You're turning down free money and the returns that the money could earn if you don't take advantage of employer matching.
The 401(k) Contribution Amount
There's no one-size-fits-all 401(k) contribution amount for everyone. It's best to save as much you can afford to without hurting your other financial goals and obligations.
You might be placing too much into your account if you don't have enough left over to pay your rent or reduce your credit card debt. On the other hand, contributing the full $19,500 per year—the maximum allowed for tax year 2021 ($20,500 in 2022)—along with any catch-up contributions, maximizes your returns. You'll have even more money working for you if your employer matches your contributions.
Many people experience life changes within a year. You should adjust your savings and portfolio balance whenever you have a big change that affects your finances, such as buying your first home or having a child.
Work through your finances to decide how much you can put into your 401(k) each 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 saving as much as possible.
Diversify Your 401(k) Portfolio
Your portfolio is the collection of assets you have. You have nine investments in your portfolio if you have three mutual funds, three stocks, and three bonds. This mix is also diversified. It's made up of different assets, which reduces the risk.
You have many options for planning your diversification. One is the "100 minus age" rule. The percentage of stocks in your portfolio should be the number you arrive at when you subtract your age from 100. The rest should be made up of mutual funds, bonds, or other investments. Your portfolio should be 60% stocks, with the remaining 40% in mutual funds and bonds, if you're 40 years old and setting up your 401(k).
Manage Your 401(k)
You can go on about your work and life and let the 401(k) do its job after you've set up your deferral percentage and chosen your investments, but you should follow a few maintenance tips.
Rebalance Your Portfolio
A 40-year-old using the "100 minus age" technique would rebalance their 401(k) by reallocating their stocks into mutual funds or funds into stocks to reach the percentage required.
You shouldn't have 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 having to move money back and forth during market ups and downs.
Increase Your Savings Rate
Don't forget to give your 401(k) a raise as well when you get a raise. You might increase your 401(k) deferral by at least 1% if your employer offers you a 5% raise. You'll still enjoy the raise, but you'll also increase your savings.
Avoid Making Premature Withdrawals
Most 401(k) plans offer a hardship withdrawal option, as well as a loan option if you find that you have to take money out of your plan before you retire, but there are limitations and downsides.
A withdrawal could cost you a 10% early withdrawal penalty on money you take out before age 59 1/2, depending on what you spend the money on. You'll have to pay it back with interest by a certain time if you take a loan from your 401(k).
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any one investor. It might not be right for all investors. Investing involves risk, including the loss of principal.