When it comes to retirement, no topic is more important than the 401(k). Although there are other options that will give you money during your golden years, most likely a large part of the money will come from this account. And if you’ve already chosen this option, here’s how you can invest your 401K money wisely.
The first step will always be to find the money to save in the account. But then you have to think about where to invest it, considering the possible risks that the future will bring, and this is precisely the point where most people have problems. According to a Schwab survey, more than half a million 401(k) plan holders wish it were easier to choose the right investments.
And with good reason. After all, no one knows what the future holds and it might go well or it might not go as well as you hope. However, there are ways to combat this, which we will show you later.
Now, in order to invest, the most important thing is to understand how the 401(k) works and what the rules of the game are.
Table of Content
- What is a 401(K)?
- What are 401(k) plans?
- How much money should you invest?
- What are the best ways to invest my 401k retirement?
- Establish a plan and monitor it
- Transfer your 401(k)
What is the 401(K)?
Although the 401(k) plan was originally designed to become the primary retirement investment vehicle for workers in the United States, the decline of pension plans since the 1980s has forced 401(k) plans to comply with that role. The main consequence for most new workers is that the biggest burden of saving for retirement now lies mostly in this financial tool.
401(k)s help in the process of guaranteeing you a tax benefit, as they first help you defer a pre-tax portion of your salary and, on the other hand, allow you to compound your savings tax – free.
Throughout this process you will also have to pay income taxes on any distributions you take. And, if your employer allows it, the new Roth 401(k) flips this process on its head, removing your tax benefits up front and allowing you to take distributions tax-free later.
What are 401(k) plans?
Although mutual funds are some of the most common 401(k) investment options, some companies are already beginning to offer ETFs. There are different types of mutual funds and some of them range from the most conservative to the most aggressive. These are typically found under different names, such as conservative, balanced, moderate, or value. However, all the big firms use similar words to name them.
Conservative funds are those that try to avoid big risks. In this sense, they usually offer options such as high-quality bonds and other safe investments. By placing your money here, the value will grow in a controlled, predictable and slow way. Also, you will rarely lose the money you put in, unless a global catastrophe occurs.
These are aimed at the medium risk ranges, investing in solid and stable companies that are worth less than they should. Normally, these corporations pay dividends, but they are expected to grow modestly, so the profits will not be as great, and at the same time, the risk will not be as great either.
Balanced funds add some options to the mix, which include risky and not-so-risky investments like stocks and bonds. The term moderate typically refers to the risk involved in owning investments.
Aggressive Growth Funds
Aggressive growth funds are typically looking at new companies that could grow quickly, like the new Apple or Tesla. However, you must be careful because just as you could get richer faster, you can also get poorer if it is not invested correctly. In fact, over time, funds can fluctuate widely between big wins and big losses.
If we look at the options above, there are endless variations. Many of these are normally found in specialized funds, which invest in emerging markets, new technologies, utilities or pharmaceutical companies. When we talk about specialized funds, these are responsible for investing specifically in one of them.
Based on your possible retirement date, you could look for a target-date fund, which specializes in maximizing your investments over time so that you can achieve the retirement fund you hope for.
Honestly, this is not a bad idea, considering that funds tend to be more aggressive at the beginning and become conservative as time goes by, like what happened with Google or Disney stock at the time. However, it is recommended that you take a look at the rates, since some of them are well above average.
How much money should you invest?
If you’re still a long way from retirement and struggling with current issues, you might think your 401(k) isn’t exactly a priority. However, the combination of employer match and tax benefits make the theme irresistible.
When you’re starting out, your goal should be to make a minimum payment on your 401(k). That minimum should be the amount that qualifies for your employer’s full match. To get the full tax savings, you must contribute a maximum annual contribution.
Lately, most employers contribute a little less than 50 cents for every dollar the employee puts in, or 6% of your salary. This is a 3% salary bonus. Plus, you’re reducing your federal taxable income when you contribute to the plan.
As your retirement date approaches, you may also begin to accumulate a higher percentage of your income. Considering the time horizon isn’t that far off, the dollar value is probably much larger than it was in your early years, even when we factor in inflation and income growth. For the year 2022, taxpayers can contribute up to $20,500 of their pre-tax income, while people over 50 can contribute an additional $6,500.
In addition to this, as you get closer to retirement, you can start reducing your marginal taxes by contributing to your company’s 401(k) plan. When you retire, your taxes may drop, allowing you to withdraw your funds at a lower tax assessment percentage.
What if I have low income?
The federal government promotes retirement savings so much that it offers extra benefits for low-income people—and they’re not that low. This is called the Saver’s Tax Credit, which increases your returns or reduces the taxes you owe by up to 50% of the first $2,000 ($4,000 if you enter taxes as married jointly) that you put into your retirement plan -either 401( k), IRA, Roth IRA or any other similar plan.
This discount is in addition to the regular tax benefits of these plans. The size of the percentage depends largely on the adjusted gross income of the tax year to which it refers.
NOTE: The limits for the Savings Tax Credit were increased in 2022. Single filers and married individuals filing separately must earn a maximum of $51,000, while married couples filing jointly are capped at $68,000. As for heads of household, this was increased to $51,000.
What are the best ways to invest my 401k retirement?
In itself, the process of investing 401(k) money should not be difficult, since companies usually offer a series of plans that you can join and they do all the heavy lifting. However, there is a lot of preparation work that you must do before selecting the one that best suits what you are looking for. Let’s look at the factors you need to know before you invest money in your 401(k).
Take into account the risk
Although some people think that investing money is very risky, there is a greater risk in not investing it. After all, your money can be devalued if you don’t invest your retirement savings.
For example, let’s say you have $10,000. If you don’t invest this money, this same amount can buy only half its value after 30 years, taking into account inflation. But if you invest your 401(k) money for a 7% annual return, you’ll have $75,000 by the time you decide to retire —and that’s not counting contributions.
Clearly, the best decision is to put money to work. But how can you do it?
The answer is to put your money in a fund that is careful enough to guarantee an appropriate return. In other words, you must invest it in such a way that the risks decrease.
Stocks, also known as equities, are the riskiest form of investing, while bonds and other forms of fixed investment are typically less risky. Just as you can’t keep your money in cash forever, it’s also no good being swayed by the spectacular returns on investment offered by newer companies.
Instead, it’s best to make a path that indicates appropriate amounts of risk and keeps you headed in the right direction for the long haul.
Consider your age
Although many people often overlook this factor, the truth is that it can be quite important. The reality is that it is not a question of age per se, but of the number of years of effective investment remaining.
As a basic rule, younger people can invest a higher percentage of their funds in risky funds, while older people should reduce risks. By doing this, at best, the funds will pay out a large amount of money; while in the worst case, there will still be time to recover the losses, considering that the retirement age is quite far away.
As time progresses and they approach retirement age, people should reduce holdings in risky funds and move toward healthier funds. In an ideal scenario, older investors have accumulated those big gains in a safe place, while continuing to accumulate money for the future.
Traditional investment systems have some internal rules in which the percentage of value invested in the stock must be equal to a range that varies between 100 or 120 minus age. Ultimately, 120 is taken as the starting point, considering that life expectancy has increased in modern times, and provides a more accurate result.
However, Mark Hebner, founder and president of Index Fund Advisors and proponent of this review, does not recommend relying solely on this methodology. He also suggests using a risk-bearing survey to better assess investors’ stock-to-bond ratio.
If you want some other incentive, experts recommend investing 10% of current income as an easy way to calculate how much to save for retirement. They also suggest putting up 15% to make up for lost time, in case you’ve been contributing less or if you need to recover from a recession or global turmoil.
Think about the amount of money you need for your retirement
Generally speaking, many financial advisors recommend having enough money set aside in retirement funds, as well as in other sources of income—such as social security or pensions. In this way, you can replace 80% of your income before retirement age.
If you have determined how much money you will receive from other sources of income, you can use a conservative estimate of 5% or 6% per year in investment returns from your 401(k) to figure out the amount of balance you will need to generate the additional income, from way you can achieve that 80%.
Another quick way to figure out the estimated amount you’ll need to have saved is to take your pre-retirement income and multiply it by 12. For example, if you make $50,000 a year and are considering retirement, you should have approximately $600,000 saved in your 401(k).
But if you want to have a more secure and comprehensive way of knowing this, you could use one of the many withdrawal calculators on the internet. Many if not all financial institutions that manage 401(k) plans offer online and interactive calculation tools that tell you everything you need to know about your retirement. This will allow you to assume and automatically calculate the savings required to achieve your goals.
Typically, these companies also have representatives who are knowledgeable about the subject and can guide you through the process. It is recommended that you take advantage of these resources if they are available to you, especially if you do not have a financial advisor to help you with this issue.
Decide the amount of risk with which you feel most comfortable
Investors who still have decades to invest can take higher risks at first and gradually lower their risks as retirement time approaches. As a rule, you can subtract 110 or 120 from your age to get the percentage of your portfolio that must be invested, while the rest must be placed in investment bonds.
Of course, you should keep in mind that this rule does not take some factors into consideration, such as your risk tolerance. In this sense, you should ask yourself the following: if the market falls by 50%, do I have the stomach to withstand it knowing that it will go back up? Or maybe you could make a mistake and sell?
If you are the type of person who jumps ship with every drop, it is best to look for forms of investment that contain less risk. On the other hand, if you are one of those who think that life is one and you live for adrenaline, you could consider a higher risk.
Weigh your investment options
401(k) s tend to be small investment selections that are curated by your plan provider and employer. In this sense, you will not be the person who selects the stocks and bonds in which the money will be invested, but it will be the mutual funds -preferably an ETF or an investment fund-, which are in charge of bringing your money together with that of other investors to buy small pieces of many related securities.
Mutual funds are divided into several categories. Your 401(k) will likely offer at least one fund in each of the following :
- US Large Caps : Usually these are the largest companies found in the national territory.
- US Small Caps – This refers to emerging and alternative markets such as emerging natural resource companies and investments in real estate companies – the latter is not provided in all plans.
According to David Walters, a financial planner at Palisades Hudson Financial Group, it’s best to put more money into larger asset classes, such as large caps, and less money into small caps, as they are not assets. that will last for long periods of time.
This means, for example, that you can place 50% of your participation in a large capital fund, 30% in international funds, 10% in small capitalization funds and distribute the remainder among the other categories.
The selection of bonuses in the 401(k) tends to be even narrower, but you will usually be offered a full bonus pool. If you have access to an international bond fund, you could also put a small part there to diversify your money more globally.
Minimize expense ratios
Investments carry expense ratios and rates, which can vary quite a bit. Normally, this is charged as a percentage of the amount of money invested. You may find that your 401(k) offers only one option in some of the categories above, but when you have a choice, you should also look for the cheapest option – usually index funds.
Index funds invest by tracking an index, such as the S&P500, so they are less expensive than a mutual fund, which is actively managed by a professional. However, you will have to pay a person to control the money and this does not always translate into higher profits.
Even the smallest differences in rates can have a big effect over long periods of time. For example, let’s say you invested $100,000 and it averaged a 7% annual return. If a fund charges you a ratio of 0.8%, that means that -after 30 years- you would have to pay $70,000 more in return on investment than another that charges 0.4%.
Expense ratios are shown on each 401(k) plan provider’s website, as well as the fund’s prospectus.
Learn to outsource
If you haven’t entered this world or are paralyzed with fear, you probably benefit from a little help. There are several options that will cost you some money, but might give you a little more peace of mind.
The first is a target date fund, typically found in almost every 401(k). These funds have a year in their names and are designed to correspond to the year you plan to retire. If you’re 30, for example, you should be looking at funds that are around 2050. If you put all your 401(k) money in these funds, it will take care of diversifying for you and automatically reduce risk as you grow. you approach that year.
Another option that might be superior to a target date fund is a robo-advisor or online planning service. Some of these companies, like Bloom, take care of managing your 401(k) with your existing provider, placing an asset allocation and automatic rebalancing. Planning services offer access to a human advisor for a reduced price, who will be in charge of giving you comprehensive guidance on your finances, including how to invest your 401(k).
Set a plan and monitor it
Once you have established a portfolio, you need to monitor its performance. Keep in mind that various sectors of the stock market do not always move quickly or linearly. For example, if your portfolio has large-cap and small-cap stocks, it’s very likely that the small-caps will grow faster than the small-caps. If this happens, it may be a good idea to rebalance your portfolio, shifting your small cap gains to large caps.
Although this does not seem to make much sense, since it is about replacing the best performing stocks in your portfolio with those that have lower returns, you must take into account that your goal is to maintain the allocation of assets. When one part of your portfolio grows faster than others, your investments become unbalanced in favor of your best-performing investments. If your financial goals haven’t changed, you should rebalance your investments to maintain a safe investment strategy.
Another important aspect is not to touch the investments. It is very easy and tempting to borrow money, putting up part of the investments as collateral, when times are tough. However, this negates your investment tax benefits, as you will have to pay back your loan with tax-paying dollars. On top of that, you will have to pay interest and possibly surcharges and fees on the loan.
According to experts, this option should be resisted, as this usually means that you need to do a better job of planning cash reserves, savings, spending, and generally budgeting to achieve your financial goals.
Some people argue that paying yourself with interest is a good way to build a good portfolio, but a better strategy is not to interrupt the progress of your growth vehicle to save for the long term from the start.
Transfer your 401(k)
Most people change jobs more than a dozen times in their lifetime. If you’re someone who withdraws money from your 401(k) account every time you get a new job, you should take a look at the rules for withdrawing your 401(k), as this is often a bad strategy.
If you make a withdrawal every time you change jobs, you won’t have anything when you really need it, especially since you’ll have to pay taxes on the funds along with a 10% penalty on the amount for being under 59. Even if your balance is very small, you can move that money into an IRA and keep the money growing.
If you have a new job, you’ll also be able to move your money from your 401(k) to your new employer’s plan, if the company allows it. No matter what choice you make, the important thing is that you roll over your 401(k) instead of withdrawing the money. In this way, you can avoid the risks that penalties bring.
Building financial independence or a gateway to retirement begins with saving any amount of money possible. The pay-your-self method works very well and is the only reason employers’ 401(k) plans are so good at raising money.
Once you understand the financial literature of companies a little better, you may be interested in the wide variety of investment options that the 401(k) plan has to offer. In any case, you will probably enjoy watching your money grow each quarter.