You want to have enough money to live on in during your retirement years without worrying about whether Social Security will still be available for you. A 401(k) plan offered through your employer (or an IRA) is a great way to save money for retirement. But, they can often be confusing! Check out these 10 tips for how to make the most of your 401(k):
Determine Your Optimal Asset Allocation
Some people treat investing like a hobby, so they enjoy reading and researching different mutual funds and their managers. However, few people are inclined to learn and maintain the skills necessary to put together their own portfolio of funds.
Building a portfolio requires an understanding of asset allocation. Asset allocation is a fancy way of saying, “Don’t put all of your eggs in one basket.” It’s the way to diversify your portfolio so that you can balance out your goals, risk tolerance, and investment time horizon.
You choose your optimal asset allocation by determining how much you want to put into stocks, bonds, and money markets. The more risk you want, the more you’ll invest in stocks. The more safety you want, the more assets you’ll put in bonds and money markets.
Take Risks While You’re Young
If you are a young investor, you may be working and earning money for 30 or 40 more years. Your time horizon is long. You may want to build a portfolio for long-term growth that has the majority of the investments in stocks.
If you are in your 50s or older, then your time horizon is shorter, so you may want to put more of your money in less risky investments like bonds, money markets, and stable value funds.
The younger you are, the more stocks you should be in. Why? Because you’ll have more time to make that money back in the long run.
Rebalancing refers to the process of bringing your asset allocation to your desired levels given your changing goals.
Once you have decided on your asset allocation, you should then rebalance your account at least once a year. You may assume that you can just “set it and forget it”, but you’ll have the most long term success if you make the effort to rebalance. Retirement plan investing is not for spectators — that's why those who invest in them are called participants.
Take Advantage of Your Employer Match
Hopefully, you work for a company that offers a matching contribution to further assist in your retirement planning. The employer matching contribution works like this: up to a certain percentage limit, your company matches whatever amount you’ve put into your 401(k) yourself.
The matching formula is usually expressed as a percentage of how much you are contributing to the plan. For example, a popular matching formula is 50 percent of the first 6 percent. In English, that means that the company will make a matching contribution of 50 cents into your account for every dollar you put away to a maximum of 6 percent.
In the language of common financial sense, employer matching on a 401(k) is free money that you should take advantage of.
Track Your Progress
There are different ways to measure the progress of your 401(k) over time. One of the more popular measurements is made by comparing your account’s return against the return of broad market benchmarks such as the S&P 500 or the Dow Jones Industrial Average indexes.
However, this is a flawed comparison because none of these benchmarks ever retire. None will ever be expected to pay out a reliable retirement income. None are aware of your personal needs, time frames or appetite for risk. Raw return percentages don’t necessarily mean that you have been successful either.
A better and more appropriate way to measure your progress is to compare your account balance against your long-term retirement goals. A good way to do this is to use the retirement planning calculator tool that your 401(k) plan provider has set up for you on their website.
Remind Yourself That Your Sacrifice Is Worthwhile
A popular myth about 401(k) plans is the belief that your contributions will not amount to much by the time you retire. This is accepting defeat before you’ve attempted to reach success.
The younger you are, the more money will come from the returns of your investments, not the contributions themselves.
The most important thing to remember is that no matter when you begin or at what amount, compounding your contributions will bring you much closer to your goal than you think. The cost of waiting to put money into your 401(k) plan is extremely high. Even worse, there are no do-overs!
Don’t Borrow Money Against Your Account
People often think, “Borrowing money from my account while I’m working won’t really matter in the long run because, after all, I’m paying myself the interest.”
Let’s take a closer look at that, though. If you take a loan on your 401(k) you’ll have to pay taxes twice on the same dollars. Here’s how.
The first tax occurs when you withdraw the money during retirement. Everyone recognizes that. The second tax occurs when you take a loan. Taking the loan is not a taxable event, but think about the money that you’re using to pay back the loan.
It’s “after-tax” money that was taxed from your paycheck just to go back into your plan to repay the loan. Not such a great idea after all. Remember that this is a retirement account, not your personal piggy bank.
Don’t Cash Out When You Change Jobs
You will be given the opportunity to cash out of your plan once you leave. This is a critical mistake. We understand that if you leave your job and don’t have a new job lined up, it is very tempting to just take the check.
There are many disadvantages to choosing this option. You will have to pay taxes on the full amount that you receive and will most likely have some of the taxes withheld before you even receive your check. If you are under age 59 and a half, you will also have to pay a 10 percent penalty for taking the money before retirement.
The biggest disadvantage of all is that you will destroy everything you’ve worked for, financially.
Instead, roll it over to your new employer’s plan and continue investing as you were before.
Take Care of the Legal Documents
It’s important to have your legal documents in order so your assets can go to the right people when you pass away.
First and foremost is a will, which is a document that instructs how your assets will be distributed to among your surviving heirs.
Then you’ll choose the power of attorney, which allows someone else to step in on your behalf concerning your financial affairs if you’re incapacitated or otherwise unable to make financial decisions for yourself.
And finally, a healthcare proxy, which authorizes someone to act on your behalf for decisions related to medical issues.
Let the Professionals Handle It
If you’re really confused, the good news is that most 401(k) plans have actively managed portfolios to choose from.
The main advantage of managed portfolios is that the fund manager chooses the mix of all the funds you invest in (the asset allocation). The manager determines the percentage of large, midsize, and small companies, as well as the mix of growth and value styles. Furthermore, they determine the mix between stocks and bonds.
Simply put, you are allowing the fund manager to make all of the asset allocation decisions within one investment.
By allowing the professionals to determine the mix of investments and monitor their progress, you are freed up to channel your energies into other activities that you may find more productive.
Harris Nydick and Greg Makowski are the authors of Common Financial Sense, a complete step-by-step guide to making wise investment decisions to fund the retirement you deserve. They are also the cofounders of CFS Investment Advisory Services, L.L.C.