401(k) Investing: Maximize Your Retirement Plan
Managing Your 401(k) for Maximum Returns
Investing in a 401(k) retirement plan is a popular method for achieving a successful and happy retirement. By starting early and managing their plans, many investors have enjoyed long and comfortable retirements. Here are some tips for maximizing your 401(k) investment.
A 401(k) is a retirement investment account offered by employers to their employees. Generally, these investment accounts are designed and managed by investment managers that are contracted by the employer.
As these are accounts designed to use the power of compounding interest to earn returns, they can be built from several types of investments.
It's never too late to begin investing in a 401(k).
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 your employer offers a match of 50 cents for every dollar up to a maximum of 6% of your pay, try to contribute 6%. If 6% of your income is $100, your employer will match it with $50, increasing the amount to $150. That equals a 50% rate of return before your contribution is even invested.
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.
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. 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 some investing basics before choosing your 401(k) 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.
There are a few steps new 401(k) investors can take to help them figure out the best strategy. First, study the types of investments and learn as much of the terminology as possible. If your employer provides assistance, training, or information about the types of assets in a 401(k), consider using them to become familiar with how they work.
Second, complete a risk tolerance questionnaire, identifying a risk profile and suggesting mutual fund types and allocations accordingly.
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.
Internal Revenue Service. "Issue Snapshot - 401(k) Plan Catch-up Contribution Eligibility." Accessed Jan. 8, 2021.
Internal Revenue Service. "COLA Increases for Dollar Limitations on Benefits and Contributions." Accessed Jan. 8, 2021.