401(k) plans are a source of confusion and fear for many of us. Here's what you need to know about them.
If you’re lying awake at night wondering if your 401(k) is properly invested, it’s not much comfort to know that millions of other Americans are probably losing sleep over the same thing.
More than half of Americans (52 percent) find explanations of their 401(k) investments more confusing than explanations of their health care benefits (48 percent), according to a poll by Charles Schwab that queried more than 1,000 401(k) plan participants. Nearly half have felt they didn’t know their best investment options, and more than a third were stressed out about properly allocating their 401(k) dollars.
It’s understandable. Our 401(k) plans were never intended to be a primary path to retirement. They were developed in the 1980s for highly paid corporate executives to shelter additional investments from taxes — a supplement to their companies’ old-fashioned pension plans. Only later did companies decide to offer them to employees in place of traditional pension plans.
Although 401(k) plans may not be ideal, they’re what many of us have to work with. Here are seven ways to wring the most out of your retirement accounts:
1. At the very least, max out your employer contribution
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Find out if your employer matches your 401(k) contribution and, if so, what the maximum contribution is. For example, if your employer matches your contributions dollar for dollar up to 6 percent of your $4,000 monthly salary, you’ll get $240 free in your account for the first $240 you save. If you don’t take advantage of your employer’s match, you’re throwing away free money.
Don’t stop there, though. If you can, add more to your 401(k). The maximum the IRS allows you to save in a 401(k) in 2016, if you are 49 or younger, is $18,000. Add another $6,000 if you’re 50 or older.
2. Bone up on 401(k) investing
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To start, watch this 90-second video primer for beginner investors. Your 401(k) allows you to choose among three types of investments:
- Stocks: When you see the word “growth” in the title of an investment option within your 401(k), that’s a clue that stocks are involved. Stocks, basically ownership in a company, offer the most potential for reward, but they also present the greatest risk.
- Bonds: When you see “income” as an investment option, you’re probably looking at a fund that contains bonds. While stocks are an “ownership” investment, bonds are “loanership.” You’re lending money to a company (corporate bonds), local government (municipal bonds) or Uncle Sam (Treasury bonds). Bonds pay a fixed rate of interest, come due on a certain date and are backed by the company or government agency that issues them, all things that generally earn them the reputation of being safer and more stable than stocks.
- Cash: When you see the words “money market,” you’re probably seeing a fund that’s basically a cash equivalent. Like a savings account, these funds don’t earn much, but the risk is lower than either stocks or bonds.
3. Decide how much to put in each investment type
Here’s a simple rule of thumb: Subtract your age from 100. The figure you get is the maximum percentage you should have in stocks. Say you’re 20. You could have up to 80 percent in stocks under this rule of thumb. But if you’re 70, keep it to 30 percent because stocks are riskier and, at 70, you have fewer years to make up any losses. You don’t want a market downturn just as you’re about to retire.
These percentages aren’t set in stone. It’s just a guide. Adjust up or down to suit your needs and your risk tolerance.
Divide the remaining part of your 401(k) equally between an intermediate (meaning neither long- nor short-term) bond fund and a cash equivalent fund.
4. Keep expenses down
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Investment fees can dig deep into your profits. Focus on keeping expenses super low. The best way to do that: Invest in index mutual funds.
“One of the most common indexes is the Standard & Poor’s 500, known as the S&P 500, which represents a broad cross section of 500 large American companies,” explains CNN. So an index fund is a great way to own hundreds of big companies and, because it requires little management, an inexpensive way as well.
5. Don’t stress over timing
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No one expects amateurs to know when to buy and when to sell. Even the pros can’t seem to get that right. Fortunately, there’s no need to worry if you use a simple system called dollar cost averaging: Make your investments in fixed amounts, for example, $100 every month.
This method gives you insurance against market dips because you’re buying more shares when they’re cheap and fewer when they’re more expensive.
6. Forget the experts
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Ignore actively managed funds. They’re more expensive. They often don’t outperform index funds. And they require you to try to figure out which experts you should invest with. While some managed funds have had excellent results, identifying the winners can be a crap shoot. The Los Angeles Times writes:
In the 10 years that ended June 30, $10,000 invested in the average fund that owns a diversified mix of large-capitalization, or blue-chip, U.S. stocks grew to $18,840. But the same amount invested in the Vanguard 500 Index Fund, which tracks the Standard & Poor’s 500 index, grew to $20,002 — $1,162 more than the average fund, according to data from financial research firm Morningstar Inc.
After 25 years, the Vanguard 500 Index Fund had accumulated $99,503, a total that’s $24,000 more than the average actively managed fund over the same period.
7. Get the lowdown on target date funds
These popular mutual funds are appealing because they take a lot of the work out of investing. You choose the date when you want to retire — 2030, for example — and the fund is supposed to do the rest, rebalancing your investments periodically to meet your goals.
Check out our tips for choosing the best target funds. As this article points out, target funds tend to have relatively high fees, but it’s not that hard to emulate one of the better target date funds on your own, cutting the fees in half. Ask yourself if you really need all that expensive professional help.
Are you confident that your 401(k) will produce the money you need when retirement comes? Share your thoughts below or on our Facebook page.
Ari Cetron contributed to this post.