Employer sponsored retirement plans create an easy way to save for retirement. It is simple to enroll, and you gain immediate tax benefits to spur participation. Include the incentive of a company match and that equals you getting free money when you save for retirement.
The Tax Benefits: Being enrolled in a 401K immediately reduces taxable income, allowing you to save more with a smaller impact on your wallet. Add a company match, which is like receiving up to a 6% raise, and you are directly increasing contributions, provided you contribute enough to maximize the benefit. Account funds grow tax-deferred, until retirement. Money must remain in the account until you reach 59 ½ or meet a qualified exception to avoid a 10% early withdrawal penalty. You pay taxes as you draw funds.
Higher Contribution Limits: Company retirement plans provide higher contribution limits than individual plans. An IRA allows a maximum contribution of $5,500 per year with an extra $1,000 when you reach 50. 401K plans permit deposits up to $18,000 with a $6,000 catch-up threshold for over 50 contributors.
How 401Ks Work?
The Partnership: Employers establish a 401K plan through a partnership with an administrator such as Fidelity Investments, Charles Schwab, or Vanguard. The chosen administrator works with the company to select a group of diversified funds from which investors may choose. Fees and administration costs depend on the size of the company, percentage of employee participation, account balances, and other factors which impact costs.
An Automated Process. Auto enrollment for new hires is a growing trend which automatically begins an investment program for all employees. The advantage of such programs is an increase in participation. However, you should not depend on auto enrollment to set aside enough money for retirement or select funds that meet your investment needs.
You're Enrolled… Now What?
Signing up for your 401K is step one in a two-step process. To meet retirement goals, you must now create a diversified portfolio, which addresses both your time horizon and risk tolerance. In other words, you must decide how conservative or aggressive you want to invest to ensure you have enough money by the time you are ready to retire.
One of the biggest challenges with company plans is knowing what funds to choose with no guidance. Only licensed advisors may make specific fund recommendations on investment products, and companies do not typically hire advisors offering employees advice on 401K selections.
The time horizon answers the question, how far are you from retirement. Do you want to retire early by age 65, 70, or later? Choosing an age defines how long you have to save and helps you estimate the number of years you must fund in retirement.
The market fluctuates daily with larger swings significantly impacting investment dollars. In general, the closer you get to your target retirement date, the more conservative you want to invest because you have less time to earn back losses. Account movement does not become an actual loss or gain until you sell the investment.
Your allocation might look something like this:
Comfort with Market Risk
Investments by their nature involve different types of risk. You must choose which risks you want to take and to what extent. Conservative options such as CDs and bonds may offer more stability, but may not grant high enough returns to meet your goals.
On the other hand, emerging markets, new technology, and trending stocks can have a fast rise and fast fall with only a few big winners. The gamble is typically higher, in exchange for a higher return on the winners.
Each year offers different winners and losers from an earnings perspective. Diversifying your portfolio provides a way to lower risk and raise the rate of return because you buy funds across different classes to take advantage of market trends.
Where to Invest
You must choose an allocation for your investments as a percentage of your contribution. You can choose to place 100% in one fund, or across multiple funds. Most employees do not make frequent changes after setting up an account, making it an important decision with long term consequences.
When deciding your allocation, consider both fund classes and the fees charged to the fund. Fees typically range from around 1% to 3%.
Stocks versus bonds: Stock funds buy a percentage of company ownership, where a bond loans the company money. Bonds pay a set interest rate, where stocks can pay dividends and increase in value based on the company’s performance. Stocks are also tied to market volatility.
Mutual funds are the most common option in a 401K. They offer a basket of stocks and/or bonds, based on the goals of the fund. A mutual fund spreads your risk across dozens (or even hundreds) of companies.
Mutual Fund Classifications: Mutual funds rank by company size, industry, and other factors. You choose between large, mid or small-cap funds. Subclasses include value or growth funds which indicate the level of aggressiveness. International, global, and emerging markets give you access to international companies. Sector funds specialize in a specific industry such as energy or technology.
Choosing the Investment Strateg
Set it and Forget It
Many companies provide balanced or target date funds which automatically adjust based on your age or time horizon. The advantage of these options is that you choose one fund and the manager changes the allocations based on when you will need to convert deposits into withdrawals. The downside is that the fees on target date funds tend to be among the highest.
Least Expensive Funds
Index funds have the lowest fees because they track an index, rather than pay an active manager to buy and sell funds. The lower expense ratio will save money, and funds often perform as well as actively managed funds with similar allocations.
When choosing the right strategy for your needs, consider all household assets, including those outside your 401K, along with long-term personal goals.