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How to Invest in Your 401k
So you’ve filled out your 401k contribution form.
Now it’s time to decide on an investment allocation – in English: how your money that is now being contributed each month to your 401k plan will be allocated.
For example, if you are 100% allocated in stocks (also known as equities), then you will be exposed to a lot of risks.
Stocks are typically a riskier investment than bonds, for example. Because you, the investor, are taking on more risk by buying stocks, you are also more likely to see a higher return, if and when the stocks perform well.
Conversely, if you decide to invest in bonds, which are typically a more conservative and less risky instrument, you’ll also not see such high returns as with stocks but your money is likely safer than it is with stocks (fewer fluctuations if the markets become volatile).
That being said, typically, younger investors should invest in stocks because even if we see a period of negative returns and you lose a portion of your money in the stock market – time is on your side.
In other words, you have decades on your side that give you the chance to make up for investment losses.
Remember, you will be rewarded if you maintain a long term investment mindset – keep investing, be consistent, and don’t take your money out of your investment account.
When you are given the option to contribute to your 401k, you are also typically given the option to select investment funds within your 401k.
(In other words, how your money will be allocated in your portfolio each time money is contributed to your 401k).
Each 401k plan provider (some providers include John Hancock, Betterment, etc.) generally maintains its own set of funds for you to select and invest.
What does this mean?
This means that you will be restricted to the types of funds you can invest your money.
Typically, 401k providers offer many different funds (sometimes ranging from 20 to 50 or more fund types) but again, you are restricted.
In contrast, if you were to open a regular investment account, you would have hundreds if not thousands of different investment fund options – there are (in general) no restrictions on how you can invest your own money.
However, because you are using a work-sponsored 401k plan, which is hosted by a 401k provider, you will have to abide by the provider’s fund options.
You’ll have the option to select the percentage of your contribution which is to go to which type of investment fund within your 401k.
For example, let’s say you select for 50% of your contribution to be invested in an S&P 500 index fund while the other 50% of your contribution is set to be invested in a small-cap index fund.
You won’t have to fill out your allocation every time your money is contributed toward your 401k.
This will be automatic, and every time your contribution is deducted from your paycheck, this contribution will be automatically allocated toward your preferences that you have indicated in the beginning.
Keep in mind, you do have the opportunity to change your fund choices each quarter as well.
Recommended reading: 401(k) basics guide.
Should I use a Target Date Fund?
Let’s say you’re not a seasoned investor and don’t quite feel comfortable yet with how to allocate your paycheck.
That’s no problem.
Typically, 401k’s give you the option to invest in what’s known as a Target Date Fund.
This is a type of investment fund that is based on your target retirement date.
The further away you are from your estimated retirement date, the more exposure to stocks you will likely have.
The closer you are to your estimated target retirement date, the less exposure to stocks you will have. Your investment allocation will change each year, the closer you move toward your target retirement date.
So why doesn’t everyone choose this passive investment approach?
Generally speaking, target-date funds are a little more expensive than other individual funds and they also are not customized.
This means 2 things:
#1: Each fund you decide to invest your money in will cost a small percentage (such as half of a singular percent, or 0.5% or 50 basis points, which is what it is known as in the industry).
Target date funds typically cost 50 basis points (0.5%), while other individual index funds typically cost much, much less – about a tenth of a percent or 10 basis points (0.1%) or even less.
In other words, if you select individual funds over target-date funds, there will be more money in your pocket.
#2: Target date funds are not customized to your investment allocation preference.
Let’s say you are OK taking a lot of risk in your investment allocation – even if just before retirement most people at that age can’t do that – it’s very risky because they don’t have time on their side anymore.
In other words, if they lose their hard-earned money in their 401k a year or two before they retire due to stock market volatility, then it’s likely that these people will have to work for longer because they can’t make up their investment losses in such a short period of time.
If you are invested in a target-date fund, this is a type of investment choice made for the masses – and not individualized or customized for your investment preferences.
If you want a customized 401k, then it’s worth taking the time to look at the fund options offered by the 401k plan provider and carefully select those investment options that best fit your investment allocation preference.
To 401k or not to 401k
The very first question you’ll likely be asking yourself is if it’s even a good idea to defer a part of your paycheck into a 401k plan.
Is it even worth the hassle?
I’d say there are 2 primary factors to consider here:
- You need to analyze your budget and cash flows to determine if you have wiggle room in order to save money on a consistent basis.
- Does your employer provide a matching contribution (different from a profit-sharing program)?
From my past experience, it actually might make more sense to set up an investment account outside of your 401k program and invest the same amount of money per paycheck period that you would have originally committed into the 401k plan.
If there are no employer matches, then why would you want to invest your money in a retirement account that maintains certain restrictions such as imposing a penalty on you if you take any of your 401k contributions out before age 59.5?
If you were to save money in a regular investment account, no strings attached, not only do you have much more fund options, but you would also be able to access your money SHOULD you have an extreme emergency without facing any penalties if you were to take money out of your account.
Again, I do want to underline that the best way to grow your account is to AVOID taking money out of your account.
Traditional or Roth 401k?
The last aspect that I think is important to cover here – again on a high level – is whether to select investing in a ROTH 401k or in a Traditional 401k.
Let’s be clear: some companies don’t even offer the option for employees to invest in a ROTH 401k.
This is generally a newer 401k plan, which is an after-tax account.
The traditional 401k plan, which is a pre-tax plan, is much more common and has been around much longer than a ROTH plan, so chances are you’re more likely to find companies still offering only traditional 401k plans or traditional 401k plans along with the option of investing in a ROTH 401k plan.
Now, what do these fancy words after-tax and pre-tax mean?
Roth 401k: simply put (can anything in finance be simple these days?), an after-tax account does not give you any tax deduction on your current year’s tax returns.
Here’s an example: assume you earn $100,000 and you contribute $15,000 into your ROTH 401k account (if you are under 50 years old, then the maximum annual contribution limit for a ROTH 401k is $19,500).
However, your tax returns will still show that you earned a total income of $100,000, and accordingly, you’d have to pay taxes on your $100,000 income.
(Again, we are talking basics – this does not assume you taking any other deductions – we’re just talking on an adjusted gross income basis).
Traditional 401k: now let’s assume you earn $100,000 and you contribute $15,000, just like in the previous example, to your Traditional 401k account.
Guess what? Because this is considered a pre-tax account, your current year’s total income will be deducted by the amount you contribute to your traditional 401k – which in this case is $15,000.
In other words, you would now only owe taxes on a total income of $100,000 – $15,000, or $85,000.
What does this mean?
Your tax bill is lowered significantly!
Now don’t jump for joy all too fast just yet: the twist on a traditional 401k is that Uncle Sam wants his money back at some point in time.
So when you start taking money out of a Traditional 401k (or when you start taking required minimum distributions or RMDs from your traditional 401k, which begin at age 72, starting in 2020) NOW you’ll have to pay taxes on whatever you withdraw from your Traditional 401k plan.
You will NOT have to pay taxes on whatever you withdraw from your ROTH 401k plan.
Big Picture: the total amount of money you have in a Traditional 401k is not actually the total amount of money that’s yours.
Why? Because when you withdraw from your traditional 401k plan, you’ll have to pay taxes on the portion that you withdraw.
On the other hand, the total amount of money in your ROTH 401k plan is actually all yours because no matter how much money you withdraw from your ROTH 401k plan, that money is yours – you already paid taxes on it now, and you will NEVER have to pay taxes on that money again.
Ultimately, investing in a 401k plan is really a question of whether you have the wiggle room in your monthly budget to invest.
If the answer is yes, you do have extra space to invest consistently each paycheck, now it’s time to research if your employer offers a match.
If the answer is yes, stop reading and starting doing! Apply for your 401k plan now and start contributing to AT MINIMUM be eligible for the employer matching contribution.
Remember, if there is an employer match, and you don’t take advantage of this feature, it’s almost like walking away from a nice, fat check addressed to you, just lying on the side of the road.
The biggest advantage of 401k investing? Out of sight out of mind.
The final thing to take away from this how to invest in your 401k guide: your investments are consistent and invested on auto-pilot.
When was the last time you made an investment allocation change in your 401k?