The 401(k) is one of the most widely used retirement savings account in America, with 79% of Americans working for employers that offer a 401(k) plan¹.
But there is an important distinction in the language used above – employers can only “offer” a 401(k) plan – it is up to you, the employee, to make the most of it, and data shows most people simply don’t bother.
It is no wonder, nothing in our education system gives people any sort of perspective on how important saving for retirement is, much less how to actually use a 401(k) to do it the most effective way possible.
Used appropriately, 401(k)s are a game-changing retirement savings vehicle that can help you build wealth almost automatically, and provide some special benefits later in life when it is time to withdraw some of those savings.
Below are 6 ideas to help you get the most out of your 401(k):
1) Contribute Enough to Get the Full Employer Match
Many employers offer to contribute to your 401(k) on your behalf provided you contribute some yourself – this is called the “employer match.” It is literally free money, and should be taken advantage to the full extent possible.
Employer matching schemes can vary, and the language is often written in cryptic percentages that make it difficult to understand. Some may offer to match your contributions dollar for dollar - for example you contribute 3%, the company will also contribute 3%. Others may contribute a percentage of your savings - for example if they match 50% of every dollar and you contribute 6%, they put in 3%. Some may even do a combination of the two, matching dollar for dollar on contributions up to a certain percentage, then only 50% of the contributions after that.
These employer contributions are generally only matched to a certain extent, so be sure you save enough to get the maximum amount of matching contributions from your employer.
2) Choose the Appropriate Asset Allocation
How you divide your money between stocks, bonds, and cash, is by far the most important investment decision as far as its impact on your ability to build wealth for retirement. Many 401(k)s provide what are called “target date funds” that control that for you, shifting the allocation to become more conservative over time. Generally speaking, they are a good start for a novice investor, but they are not perfect.
I suggest people in their 20s and 30s invest 100% of their funds designated for retirement in a diversified stock portfolio. Young people have the time horizon to benefit from decades of compound growth, and since they are not relying on their investments to fund their present lifestyle, they have the capacity to make it through any temporary declines in their portfolio.
For more explanation, read my CNBC article: This 29 year-old financial advisor puts his money where his mouth is by investing in 100% stocks.
It is important to remember even the most aggressive target date funds include around 10% bonds.
As you get closer to retirement, your account balance is the highest it has ever been after a lifetime of investing. At this time, a temporary stock decline at the start of retirement forcing you to sell at depressed prices becomes a bothersome risk to your retirement – to say the least. You may want to consider what is called a “bond tent” – increasing your allocation to bonds up for a short period of time as you approach retirement, maintaining it for a few years, then ratcheting it back down over time.
3) Build a Low-Cost, Diversified Portfolio Using Your Investment Options
401(k) providers usually provide their employees with a complicated menu of investments that includes terms nobody understands, and expect them to just “have at it.” They only provide a few pieces of information, and actually put emphasis on ones that don’t matter.
Typical 401(k) documents only show a few pieces of information – the fund name, the designated “asset class” (type of things the fund invests in), expense ratio, and performance. To the extent possible, you will want to build a portfolio that invests in stocks (and bonds if applicable) all over the world, for as low of a cost as possible. Almost every 401(k) fund will have good index fund options that allow investors to do this – often using only two or three funds. Do not use past performance as the basis for your investment choices, because it is not an indicator of future results.
For more details, check out my Nasdaq article: 6 Steps to Build a Diversified Portfolio
4) Don’t Get Stuck on Roth vs. Traditional
You will be given the option to designate your contributions as “Traditional” or “Roth”.
Traditional contributions can be deducted from your income taxes now, which lowers your tax bill now. They grow tax-deferred as long as they remain in the account, but when it comes to withdraw those funds during retirement, the withdrawals are taxed at ordinary income tax rates.
Roth contributions are made with “after-tax” dollars – you cannot deduct them from your income now. However, when it comes time to withdraw the funds during retirement, they may be withdrawn tax-free.
The decision between Roth and Traditional depends on whether you want to pay taxes now, or later. The right choice depends on whether your tax rate will be higher or lower in the future than it is now, which in many cases is difficult to predict. So don’t get too caught up in this decision and lose sight of the more important decision to simply start investing.
5) Take Advantage of Catch-up Contributions
If you are 50 or older, you are allowed to contribute an additional $6,000 “catch-up contribution” to your 401(k) each year. Combined with the standard $19,000 contribution limit, that’s $25,000 you can save for retirement each year.
6) Preserve the Age 55 Rule
The standard age at which you can withdraw money from retirement accounts (i.e. 401(k)’s, 403b’s, and IRA’s) without paying a 10% early withdrawal penalty is 59 ½. However, 401(k) plans have a provision that allows people to withdraw their money early without penalty if they “separate from service” (i.e. retire, get fired, or quit) in the year they turn 55.
This is unique to 401(k)’s – so if you leave your job and roll everything into an IRA, you lose the ability to withdraw those funds without penalty until age 59 ½.
Final Thoughts: Seek Help When You Need It
I understand the hesitation to seek help with anything financial related, for fear of looking ignorant. But there is nothing in anyone’s educational background that could make them equipped to make these decisions, so some just put them off, or make a completely uneducated guess.
But with so much at stake, it is important to get help on some of the more important 401(k) decisions if you aren’t completely certain you can make the right choice yourself. Things like building a diversified investment portfolio out of investment options in your plan, or choosing your asset allocation are complicated, and are worth at least double checking with an expert.
Decisions like this can often be made clear by a financial advisor in minutes, not hours, and are nothing short of the difference between retiring early and retiring comfortably, or working extra years and spending less than you would prefer in retirement.
Many advisors likely won’t even charge you for this. I help just about anyone who asks me for help sorting through their 401(k) for free – feel free to get in touch and take advantage of that.
Beyond choosing investments, there is also the bigger issue of how a 401(k) will fit into your financial plan to help fund your retirement spending. Decisions like how much to save, when to retire and start withdrawing from your 401(k), and how much to withdraw, should all be made with respect to a comprehensive financial plan that is designed to fund your most important retirement goals.
When the time comes, the retirement planning specialists at Ruedi Wealth Management would love to help you build that plan.
Paul R. Ruedi, CFP® is a financial advisor at Ruedi Wealth Management in Plano, Texas.
Paul has been quoted in news publications including USA Today, Time Magazine, The New York Times, Dallas Morning News, Forbes, Inc.com, Business Insider, US News and World Report, GoBankingRates, The Street, NerdWallet, and The Penny Hoarder. He also writes articles that have been featured in CNBC, Investopedia, Yahoo Finance, Nasdaq, and MSN Money. He was named one of Investopedia's Top 100 Most Influential Financial Advisors in 2018.