Signing up for a 401(k) through your employer is one of the easiest ways for you to successfully save for retirement. Your employer takes care of most of the paperwork and your contributions to the plan are taken right out of your paycheck. However, when you first set up your 401(k), you may be overwhelmed by all the options.
How Much to Contribute
When you set up your 401(k), you get to decide what percentage of your paycheck is contributed. While the default is often 3 or 4%, don’t settle here. If your 401(k) is your only retirement savings, you likely should save roughly 15% of your paycheck if you are starting to save in your 20s. If you are just starting to save for retirement and are already in your 30s or 40s, you want to save 25% and 35%, respectively. If you are using your 401(k) along with another retirement fund, contribute enough to your 401(k) to at least get any employer match that is offered. Not doing so is leaving money on the table.
Choosing a Fund
Your 401(k) likely gives you several different fund options to invest in. You should make your choice based on the fund fees and the risk level of the funds. The fees will vary from fund to fund, and are a percentage based on the amount you invest in the fund. Funds with high fees like to claim that their performance is better than average. However, numerous independent studies have shown that higher fees don’t predict better result, and instead just eat away at your total return. You will achieve the best performance from the funds with the lowest fees.
If your 401(k) gives you a variety of funds to pick from, there are likely an assortment of risk levels. The higher risk funds typically invest in stocks, while the lower risk levels invest in bonds and cash. One of most common mistakes of 401(k) investing is just randomly selecting risk levels, or panicking and switching to a lower risk level at the wrong time. Since your retirement is at least partially riding on your 401(k), it is important to make an educated selection, and then stick with your selection.
Managing your Risk
Risk always correlates with reward. In other words, the higher the risk of the investment, the higher the reward. On average, investments gain value over time (otherwise they wouldn’t be investments). From time to time, however, investments temporarily lose value. This loss in value can last for a few months to several years. The more risky the investment, the more value is lost. But since the drop in value is temporary, you won’t actually lose any money as long as you stay invested.
Because market slumps are temporary, you are able to ride out these slumps when you are younger and further away from retirement. During this time, you should primarily invest in stocks, which are riskier investments. As you approach retirement, however, you should gradually move your investments over to bonds, which are safer during market downturns.
Set up a timeline that spells out your stock and bond allocations at each age. Of course, everyone’s risk tolerance and goals are different, but I recommend keeping 80-100% of your investments in stocks until age 40, since the full swing of a stock slump is almost never longer than 10 years.
A good example of an allocation timeline follows:
Up to age 40: 90% stocks, 10% bonds
40-45: 80% stocks, 20% bonds
45-50: 65% stocks, 35% bonds
50-55: 50% stocks, 50% bonds
55-60: 35% stocks, 65% bonds
60-65: 20% stocks, 80% bonds
Retirement: 10% stocks, 90% bonds.
Stick to Your Plan
Now that you have your plan, stick to it! When the markets slump, and your stock funds lose half their value, you’ll be tempted to bail out to cut the losses. Many people do. Don’t make this mistake! Remember that over the long haul, stocks go up. You only lose money if you actually sell your investments. Stick to your plan and you’ll be fine. Bail, and you’ll lock in your losses.
Some people deviate from their plan thinking that they can time the market to outperform the market. The problem is that nobody really knows when the markets peak or bottom out. Don’t pay attention to ‘hot tips’. They’re no better than a palm reader or weather forecaster. The only way to earn consistent returns is to stick to your plan.
Set and Forget
Your 401(k)s only purpose is to save money for retirement. Too many people view it as an emergency account or worse yet, a fun account that they can borrow from or withdraw from on a whim. While this is technically allowed, it also comes with hefty tax penalties, and will derail your retirement plans.
Set up a separate savings accounts for fun and emergencies. Leave your 401(k) alone. Let it hibernate until you retire (continue to feed it, of course).
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.