Tips for 401k Investing
Investing in a 401k plan is essential for the vast majority of American citizens to achieve a successful and happy retirement. In fact, if managed correctly, many investors can enjoy an early and wealthy retirement. Here are 10 of the best tips for 401k saving and investing.
Start Your 401k Early
It's never too early or too late to start saving in a 401k plan. Even if you're in your 40s or 50s, there's still time to build a significant nest egg for retirement. Therefore, there's not a magical age to start saving in a 401k plan but rather this simple savings advice: The best time to start saving in a 401k plan is yesterday, the second-best time to start saving in a 401k plan is today, and the worst time to start saving in a 401k is tomorrow.
Take Advantage of Compounding Interest
The sooner you start saving in your 401k, the sooner you can take advantage of the power of compound interest. An example of two different savers explains it best: Saver #1 starts saving $5,000 per year in a 401k at age 25 and continues for 10 years until age 35 when they stop. That's a total saving amount of $50,000. Saver #2 starts saving the same amount of $5,000 but waits until age 35 and continues for 30 years until age 65.
That’s a total of $150,000 out-of-pocket savings expense for them. Assuming a 7% rate of return on each of their 401k investment portfolios, which one ends up with the most at age 65? Because of getting an early start, and thanks to the power of compounding interest, Saver #1 wins, after only saving for 10 years, with a balance of over $600,000. Saver #2 ends up with about $540,000 although they saved for 30 years.
Because of compound interest, which harnesses the time value of money, Saver #1 "won" the 401k savings contest. Making compounding even more powerful, the earnings in a 401k plan are not taxed while in the account. This allows the interest to keep compounding without taxes slowing it down, as it would in a taxable account.
Pick the Best Savings Rate for You
There is no one-size-fits-all 401k savings rate for everyone. Therefore the best amount to save in a 401k plan is however much you can afford to contribute without hurting your other financial goals and obligations.
For example, if you can't pay your rent or reduce your credit card debt because your 401k contributions are too high, you are saving too much! 10 to 15% is a good amount to save in a 401k plan but you should at least invest enough to get any matching contributions your employer offers. A common match is 50% up to 6% of your contribution rate (often called a "deferral percentage").
In translation, if you contribute less than 6% of your pay, you're not getting the full match. But if you're contributing 6%, your employer is adding on 50% of that, which is 3% of your pay. That translates into a total of 9% of your income going into your 401k! Just don't leave money laying on the table, so to speak.
Properly Assess Your Risk Tolerance
One of the biggest mistakes investors make in a 401k plan is failing to identify which mutual funds are best for them. More specifically, some investors take too little risk, which means their 401k savings might grow too slowly, and some savers invest too aggressively and sell their mutual funds in a panic when a major market decline comes.
To find out how to find the best balance of risk and return, 401k investors should complete what's called a risk tolerance questionnaire, which will identify a risk profile and suggest mutual fund types and allocations accordingly.
Diversify Your 401k Mutual Fund Portfolio
When building a portfolio of mutual funds, the most important aspect of the process is diversification, which means to spread risk across different investment types. Most 401k plans offer several mutual funds in different categories. The best way to understand the concept of diversification when building a portfolio is with a good visual. Here's an example of a moderate portfolio, which is a "medium risk" mix of mutual funds appropriate for most investors, using funds typically found in a 401k plan:
- 40% Large-cap stock (Index)
- 10% Small-cap stock
- 15% Foreign Stock
- 30% Intermediate-term Bond
- 05% Cash/Money Market/Stable Value
Follow the Best 401k Management Practices
Once you've set up your deferral percentage and selected your investments, you can go on about your work and your life and let the 401k do its job. However, there are a few simple maintenance tips to follow:
- Rebalance Your Portfolio: When you rebalance your 401k, you are returning your current investment allocations back to the original investment allocations. Therefore rebalancing will require buying and/or selling shares of some or all of your mutual funds to bring the allocation percentages back into balance. For a simple example, let's say you originally chose 4 mutual funds and set the allocations to 25% each. After one year, one mutual fund grew to 30% of your portfolio, another declined to 20% and the other two stayed around 25%. To rebalance, you will sell shares of the fund that grew in value, buy shares of the fund that declined in value, and leave the others alone. This has an effect of "buying low and selling high," which is what the best investors do regularly. A good frequency for rebalancing is once per year. Most 401k plans allow for automatic rebalancing or an easy way to do it online.
- Increase Savings Rate: When you get a raise, give your 401k a raise! For example, let's say your employer gives you get a promotion that comes with a 5% raise in salary. Immediately increase your 401k deferral by at least 1%. That way you'll still enjoy a raise but you'll also increase your retirement savings.