When people start their first job, they often know they have access to a 401(k) plan, but they are not sure what it is exactly or how best to use you.
Instead of brushing it off and thinking, “Hey, I’ll do it in a few years. Retirement isn’t for a long time,”, I suggest we tackle it together.
I’ll explain what a 401(k) plan is, how to take advantage of matching (if one is offered), how to select the investments, which rebalancing option to choose, and how to strategically increase your contributions to reach financial independence sooner.
What is a 401(k) Plan?
A 401(k) plan is a tax-advantaged way to save for retirement. Typically, people make regular contributions through a payroll deduction and the money is invested in investments available in their 401(k) plan.
A 401(k) plan typically can’t be accessed until age 59 ½ or later without a 10% penalty. There are a few exceptions to this rule, but the key takeaway is that money going into a 401(k) plan is being saved with the intention of not using it for a very long time.
Some 401(k) plans offer different types of contributions. I’ve previously written about the difference between a Roth 401(k) and a Traditional 401(k).
I’d recommend reading it and familiarizing yourself with which may be better in your circumstance. You can even split contributions between a Roth 401(k) and a Traditional 401(k) if you are inclined.
Although I keep referring to only a 401(k) plan, you may only have access to a 403(b) or 457 plan. These are also types of retirement plans similar to a 401(k), but with slightly different rules. I won’t go into the nuance of those plans because I simply want to provide a broad overview of how to take control of your retirement plan, and I am using the 401(k) plan as an example.
Understand the 401(k) Match
Some employers offer a 401(k) match, which means they will contribute money up to a certain amount. Some offer a match regardless of the amount you contribute. Others will base it on your contribution.
For example, let’s assume you made $100,000 last year and your employer offers a 100% match on the first 4% of contributions. If you made zero contributions to your 401(k) plan, your employer would contribute zero, too.
Instead, if you contributed $2,000, your employer would also contribute $2,000.
Although if you contributed $10,000, your employer would only contribute $4,000 (4% of $100,000).
To take advantage of the full match, you would need to contribute up to $4,000. If you don’t contribute the full amount, you are losing out on a 100% return. Some people call it “free money” while others think of it as your total compensation package.
If you are only making ends meet, that would be a good reason to not take full advantage of the full 401(k) match, but there are very few other scenarios where it makes sense. To the extent possible, you want to fully take advantage of the 401(k) match.
There are other ways of matching. Some employers might offer a 100% match on the first 3% of contributions and then a 50% match on the next 2%. In a way, this is a 4% total match if you maximize it, but it allows the employer to contribute less if people aren’t taking advantage of the full 2% after the first 3%.
Using the same salary as before ($100,000), if someone contributed $4,000, the employer would match $3,000 (100% on the first 3%) and then an additional $500 (50% of $1,000). In this case, they missed out on the full $4,000 match because they did not contribute enough.
To reach the full match, they would need to contribute $5,000 (100% of $3,000 and then 50% of $2,000). Any contributions less than $5,000 and they would be “leaving free money on the table.” Again, you know your circumstances best and whether it makes sense to take advantage of the full match.
One other thing to be aware of is that some employers require you to contribute throughout the year while others will let you front-load it at the beginning of the year and still receive the full match. For example, if you wanted to get as much money into your 401(k) as possible early in the year, double-check with your human resources office to ensure that you won’t miss out on any of the matching.
How to Select the Investments
Selecting the investments can be tough. One easy path is to select a Target Date Fund. A Target Date Fund is exactly like it sounds. It is the date you target retirement.
What these funds do is start out more aggressive with higher expected returning investments and over time become more conservative with lower expected returning investments.
Below is an image from Vanguard to help illustrate the point.
For instance, if you selected a 2060 Target Date Fund and it was 2021, the fund will likely have high exposure to stocks. As time passes, some of the stocks will be sold and bonds will be purchased. This will continue throughout time until retirement, where it will likely be moderately conservative.
This is a good “select it and forget it” type of investment. If you know approximately when you want to retire, you could simply choose a Target Date Fund closest to that date.
The downside to a Target Date Fund is that you may have a different risk tolerance than how the fund invests. For example, if you select a 2060 Target Date Fund, it might have 80-90% stocks. You may be uncomfortable with that level of risk, in which case, it would be better to select an earlier year target-date fund or select your own investments.
Another aspect to keep in mind is that not all Target Date Funds are created equal. A 2060 Target Date Fund through Vanguard could have 80% stocks while a 2060 Target Date Fund through Schwab could have 90% stocks. I’m making up these numbers to illustrate a point. You’ll want to read the fact sheet, company website, or visit a website like www.morningstar.com to determine the allocation today and how it changes over time. From there, make sure you are comfortable with the allocation – not only now, but in the future.
Another option is to select your own investments. Most plans have 10-30 investments, which can make this a time-consuming process.
Generally, I am a fan of passive investments, which means I won’t normally pick mutual funds that are actively managed, where a portfolio manager is trying to outsmart the market to earn excess returns. Research has shown time and time again that this is nearly impossible to do consistently. To select passive investments, I normally look for something that says “Index” in the title of it. This usually means it is tracking a predetermined set of stocks.
I also prefer lower expense ratio funds. This is a fancy way of saying that the fund costs less to own. An expensive fund might be over 1% while a cheaper fund might be under 0.4%. This varies depending on the asset class. For example, the S&P 500 is extremely cheap to own. You can find funds that have an expense ratio of less than 0.08%. This means if you owned $10,000 of that fund, it would cost approximately $8 annually.
The S&P 500 is cheap because it’s an easier market to access. Other asset classes, such as US Small Cap stocks might be more expensive at 0.2% and that could still be cheap.
I mention this because I don’t want you to compare apples to oranges. You shouldn’t simply pick the cheapest fund because it’s the cheapest. If you did that, you are likely sacrificing diversification.
Said another way, you could try making chicken soup with only water because it’s the cheapest ingredient, but you’d have a lousy soup without the chicken, carrots, celery, etc. They cost more, but they complete the package.
Lastly, I prefer diversification. I hinted at it above, but it’s important to own assets that aren’t simply in the United States. The US went through a 10-year period once where it had 0% returns. I can’t imagine having a portfolio earn 0% for 10 years. I feel pain thinking about it.
The US market has done phenomenally well over the last decade which, for me, is even more of a reason to own International and Emerging market stocks. If your plan includes small company stocks, I would also include exposure to them because research has shown they offer higher returns over time, but certainly not in every 1, 5, 10, or even 20 year period. Remember, discipline and patience have historically rewarded people in the stock market.
This brings me to my last point. You always want to invest with the right timeframe in mind. If retirement is 30 years away, time is on your side and you could select more aggressive investments, assuming you can withstand the ups and downs of the market. If retirement is one year away, you potentially could still select more aggressive investments because you likely still have a 30+ year horizon where the money needs to last, but again, you might be very uncomfortable if the stock market dropped shortly before or after retiring.
Know your time frame and what level of risk you are comfortable with. During the Financial Crisis in 2008 and 2009, a diversified basket of stocks dropped about 50%-60%. Depending on the investments, it could have taken 5-6 years for you to come back to your previous high.
In summary, a Target Date Fund is a fine option if you want to quickly select an investment.
If not, I tend to look for passive investments, cheaper expense ratio funds, and a well-diversified portfolio of different asset class investments.
Please keep in mind none of this is investment advice, and you are responsible for your own investment decisions. This is meant for educational purposes and to help you get started in your own research.
Which Rebalancing Option Should You Select?
Your plan probably offers a rebalancing option, such as quarterly, semi-annually, or annually. Rebalancing is when the plan will sell and buy the investments to bring them back into alignment with your original selection.
For instance, if you selected 50% into Fund A and 50% into Fund B and the market caused Fund A to be 55% and Fund B to be 45%, the plan would rebalance by selling enough of Fund A to bring it back to 50% and buy enough of Fund B to bring it back to 50%.
There is varying research about the best rebalancing option. Similar to the investments, know your tolerance for your portfolio being out of alignment.
Quarterly rebalancing will likely mean being closer to your target allocation throughout time. If you select annually, your portfolio may drift farther away from the target, which could mean more or less risk than you want to take.
Personally, I like semi-annual or annual rebalancing because stocks tend to go up over time, and I prefer to allow my portfolio to drift away from the target and continue benefiting from rising values.
In down markets though, this could hurt. For example, if your portfolio was 50% stocks and 50% bonds before a 30% decline in stocks, your portfolio won’t rebalance for another year, which means I have less stock exposure after the decline. A quarterly rebalance might sell some bonds during a decline and buy more stocks so that when prices rebound, you are closer to your target risk level.
One thing you could do is to manually rebalance during those types of declines. Most plans allow you to go in and rebalance manually or select a new allocation for the investments.
I wouldn’t get too caught up in a rebalancing option. Any option is likely going to serve you well over time. I’d pick one and stick with it.
How to Strategically Increase Your Contributions
Lastly, I encourage nearly everybody to increase their 401(k) contributions over time. Some plans have a feature that automatically does it for you if you opt into it. If yours doesn’t, I would make an annual calendar reminder to revisit your 401(k) contribution. Although even a 1% increase in your 401(k) contribution does not sound like much, it can make a huge difference when you consider your investments compounding over multiple decades.
There is no right or wrong contribution amount to start with. If you can only do 2%, do 2%. If you can do 10% great. If you can, I’d aim for around 20%. I’ve previously written about how much you need to save to be financially independent. It will give you a good way to determine how much you should be contributing to reach financial independence by a certain age.
Once you select your starting contribution level, try to increase it 1% each year or twice a year. Continue doing it until you feel it in your paycheck. My guess is most people won’t feel a 1% increase because you’ll have less in your bank account each pay period to spend. Many people automatically adjust their spending if they have less.
I also suggest revisiting 401(k) contributions when you receive a pay raise or a bonus. Those are great times to increase your contribution because it’s money you did not have before.
Summary – Final Thoughts
A 401(k) plan is a powerful retirement savings vehicle. Over decades, small contributions can turn into large balances to support a healthy retirement.
Take the time to understand what options you have available, Roth vs. Traditional 401(k), and even possibly after-tax contributions and in-plan Roth conversions.
From there, understand your company’s match. Answer the question, “How much do I need to contribute to receive the full match?” You likely don’t want to leave “free money” on the table.
When it comes to investments, make sure you pick something! In most circumstances, you want your contributions going into investments and not a cash option. A Target Date Fund is an easy option or if you want to do more research, you could select your individual investments.
When your plan asks you which rebalancing option you want to choose, pick one. Don’t spend too much time on it.
Lastly, don’t forget to consider raising your contributions over time or when you receive a pay increase.
Good luck taking advantage of all your 401(k) plan has to offer.