Explained: 401k & Retirement Investments
Saving for the future is an essential part of having a handle on your finances. Specifically, retirement savings can have a significant impact on your life and should be taken very seriously. Choices made early on in your life in regards to retirement savings can influence how long you have to work, what kind of lifestyle you can have during retirement and what you can leave to your beneficiaries when you pass. Here are some tips to maximize your 401k retirement investments. (Note: Some of the topics below could also be used for other retirement and side investments such as 403(b)’s or IRA’s.) Invest Early & Understand Compound Interest
One of the key ways to have more in retirement is to start saving early! The amount of difference even one year can make is simply amazing. For an in-depth article about what compound interest is and how it works, check out this article by J.D. Roth. Don’t put off saving for retirement any longer, start today.
“The most powerful force in the universe is compound interest." - Albert Einstein
Invest Pre Tax
The common practice is that you should invest in your 401k with pre-tax contributions. The theory is that even if taxes go up in the future, the increased compound interest that you will get from the additional pre-tax income will greatly outweigh any taxes you will incur when you withdraw the money in retirement. To help diversify your retirement tax risk, invest in a Roth IRA also.
Get Your Employer Match
If you have a retirement account through your employer, check with your human resources department to determine whether or not the company matches any of your contributions. The general rule of thumb is to contribute at least enough to get the company match and then invest in a Roth IRA. If you are not contributing to your retirement account and your company matches, you are essentially turning down a raise. For example, if you contribute 5% to your 401k and your employer matches 50%, you can immediately get a 2.5% raise.
Be Wary of Fees
One thing to be weary of with any financial investment is the fees charged by the provider. Having fees over 1% can make a huge impact on the growth of your investment. Always look to make sure you know how much you are being charged in fees for a fund.
Actively Managed Funds
These types of investments are managed by the investment firm and the allocations are adjusted frequently depending on how the market changes. Over time these funds have not historically had better performance across the board when measured up against the market or index funds. Managed funds will also have the highest fees, so I tend to avoid them.
Target Retirement Funds
One convenient way to invest for retirement is in a target year retirement fund. These funds are managed to change throughout your life to map better to how much risk you are able to take. If you are planning to retire around 2045 you can just simply put all of your investment into the 2045 fund and as you get closer to retirement your allocations will be changed into a more conservative portfolio. These funds have fees, but are usually lower than actively managed funds.
Market Index Funds
An index fund is an investment that has money invested into a bunch of different companies, bonds or markets. They map to the trend of the market and diversify some risk by not having just a few companies in your portfolio. The most popular U.S. index is the S&P 500 Index. To see what companies and industries the S&P 500 follows, look here. These types of funds typically have the lowest fees.
Individual or Company Stocks
A higher risk option for investing is to invest in a single company. These stocks can potentially pay dividends and provide a high return, but can also provide a high loss. If your company matches your contributions with their own company stock, I would recommend trading it for what your regular allocations are. Try not to have a large portion of your portfolio be in a single company, especially the one you work for. If your company goes belly up (i.e. Enron) you might lose your job and your retirement investments if you don’t diversify.
Diversify Based on Your Risk Tolerance
One of the most important parts of setting up your retirement investments is to determine your risk profile. To find out whether you are risk tolerant or risk averse, try out this quiz. The more tolerant you are to risk, the more you would invest in stocks. If you are risk averse, you would focus more on stable growth such as bonds. Within stocks you can also diversify between Large and Small cap and international funds.
A general rule of thumb is to have the percentage invested in stock be 120 minus your age. For example, if you are 35 years old, you would want to have 85% of your portfolio invested in stocks and 15% invested in bonds. This is a relatively aggressive portfolio though, so first determine your risk tolerance first.
Re-balance Your Portfolio Annually
The last tip I have is to look at your portfolio each year or even each quarter and reallocate the balances of your portfolio. The reason why you do this is to make sure that what you have invested matches up with your investment risk profile you determined above. You need to re-balance your predetermined percents for each area you are investing in.
There is a lot to learn about retirement planning, but some of the above tips can save and make you a lot of money if you follow them.