Mismanaging your 401(k) can be a very costly mistake, and plenty of people are confused or simply not confident that they’re making the right decisions with their retirement account. Luckily, there are some basic steps to follow to ensure that you can get the right balance of safety and growth with your savings. People who contribute the right amount, save regularly, and allocate their investments properly will be able to retire without financial stresses.
How much should you contribute?
Many people simply contribute a default amount. Some set up a contribution when they first start off with an employer, then never think about it again. Automatic savings are great, but the best financial plans involve deliberate decision-making that reflects all aspects of a household’s financial goals and needs. That sounds like a complicated approach, but it’s very important.
The amount you should contribute really depends on a number of factors. A general rule of thumb is to take full advantage of your employer’s match, assuming that it’s offered. Many companies offer dollar-for-dollar contributions to your retirement account, up to a certain limit. For example, if you invest 3% of each paycheck in your 401(k), your employer will also pay that much into the account. Specifics of the matching program are usually detailed in an employee benefits handbook or the 401(k) account documentation. If you have someone in charge of benefits or human resources at work, that person should also be a helpful resource.
Any contributions above the match depend on other circumstances. For example, if you have credit card balances, it’s probably smarter to concentrate on that rather than making investments. It’s unlikely that you’ll achieve 20% average annual growth in your retirement accounts, so it doesn’t make sense to keep paying that interest rate.
If you aren’t great at forcing yourself to save regularly, then 401(k) programs can be great tools. Contributions help you build assets that never have the chance to hit your checking account and get spent. However, you need to recognize that anything going into a qualified retirement account is functionally locked away from you until you are almost 60 years old. There are exceptions that allow you to make early withdrawals without taxation and a 10% penalty, but retirement accounts aren’t designed to be accessed in the short or medium term. Saving directly into a dedicated savings account, a brokerage account, or Roth IRA will build assets that are liquid and available to purchase real estate, start a business, or handle unexpected expenses. You want to make sure that you have a few months’ worth of expenses saved in a cash account that’s ready and available for emergencies before you go overboard with your 401(k).
It’s important to understand that 401(k) withdrawals in retirement are taxed as ordinary income. That’s a great benefit if you’ll have lower tax rates in retirement, which is the case for most people. However, if you’re concerned about tax rates rising in the future to cover today’s government spending, you might want to reconsider the wisdom of deferring taxation at today’s rates for whatever they reach a few decades down the line.
How to invest your 401(k)
Figuring out the ideal 401(k) contribution is just the start. Once you have cash flowing to the account, you need to determine the best way to deploy it. Thankfully, there are some key rules that should keep you on the right track and remove some pressure from the decision-making process.
Your 401(k) allocation should reflect your time horizon, risk tolerance, and investment goals. If you have more than 10 to 15 years until you start making withdrawals, then you should prioritize growth. Younger savers should invest as heavily in stocks as possible, with limited exposure to bonds, because stocks have historically delivered significantly higher long-term returns than bonds. Most plans offer mutual funds and ETFs that mimic the performance of major market indexes or specific growth sectors, and these are great vehicles for 401(k) assets.
If you’re getting closer to retirement, it’s important to have both stocks and bonds in your portfolio. You can’t ignore growth altogether, but bonds are important for limiting volatility. If the stock market crashes just before you start making withdrawals, then your account will never have time to recover. That’s not a serious issue for investors who have the right allocation to bonds, which will retain value through a stock market crash.
Every plan offers a different set of investment options, but the simplest route is usually a target date fund that’s managed by a reputable institution such as Vanguard, Fidelity, or BlackRock. If those aren’t available, you can consult the plan’s representative or use an online risk tolerance questionnaire to determine your optimal allocation. If you maintain a diversified portfolio with the proper balance of stocks and bonds, then your 401(k) should be safe and growing.
If you contribute the right amount to your 401(k) and invest the right way, your retirement account should be an important part of a harmonious financial plan. You’ll know that you are building for a stress-free retirement with cash waiting for you the day you stop working.