Employer-sponsored 401k plans are popular investment vehicles for working Americans. Clearly understanding how these plans work is vital to successfully utilizing them. It’s important to recognize the value of taking advantage of employer matches to your contributions, and of course you should have a good grasp of the rules surrounding such plans – such as annual contribution limits. Beyond that, it’s also crucial to understand strategies regarding how to effectively invest within your 401k.
Here are 6 tips for effectively managing your 401k and the investments within your account.
1. Talk to an Advisor
While the government regulations related to 401k plans apply universally, each plan can have rules that are specific to that plan (as long as they don’t conflict with the law). That can make things confusing so a great way to get personal advice on your specific situation is to talk to a financial advisor. It is in your best interest to work with a fiduciary advisor who can provide custom recommendations on asset allocation in your 401k plan and make specific fund recommendations for your needs and goals.
2. Start Early
There is a compounding effect to investing, meaning as your assets appreciate over time, all future gains are based on that larger base. Let’s say you invest $100 today, and that investment grows by 10% this year and all future years. Next year you’ll start with $110 after this year’s $10 gain, and your 10% appreciation next year will be based on that larger base – so next year you’ll earn $11. Therefore, the longer you can take advantage of that compounding effect, the better.
It’s important to maximize your savings rate by contributing as much as you can afford (and as much as is allowed by law), but time is also an important factor to consider. Starting your retirement savings too late is just as detrimental as not saving enough. And as noted earlier: if you have an employer match, you should contribute at least as much as is required to receive the match. If you don’t, it’s like ripping up a paycheck. That match is part of your compensation as an employee – don’t refuse it.
3. Appropriate Asset Allocation in Your 401k
The key to selecting an appropriate asset allocation is determining the goals for the assets, the time horizon for those goals, and the investor’s risk tolerance. So if all those factors align between your 401k and the assets managed in your other investment accounts, then the asset allocation should be very similar between the portfolios. However, if one of those factors is very different (if the time horizon for the 401k is much longer than that of a taxable account, for example), then that would require a deeper conversation with your financial advisor to determine what is actually appropriate.
4. Fund Selection
In addition to having the proper asset allocation in your 401k, it is also critical that you have the ideal fund selection. The main things to consider when assessing which funds to invest in are diversification and fees.
Many employer-sponsored plans have low-cost index funds available, which would satisfy the need for both broad diversification and reasonable expense. But plans sometimes offer more expensive mutual funds on their lists as well, so it’s very important to look closely at the expense ratios so you know what you’re paying.
There are also some situations where a target date fund is a reasonable selection, depending on the breadth and cost of the other options available to you. As a quick refresher, target date funds are designed to give you a single, simple investment vehicle. They usually operate under an asset allocation formula that is based on what age you plan to retire, and gradually shift to a more conservative allocation as you approach retirement. If your plan does not offer a range of low-cost index funds to choose from, a target date fund can sometimes be the best choice. But if other options are available within the plan, it’s probably best to discuss that with your advisor to make sure you make an optimal selection.
5. What Should I Do With an Old 401k?
If you have changed employers, you may be questioning what to do with your old retirement plan. Whether it is an old 401k, 403(b) or other employer-sponsored plan, you should probably discuss your options with your financial advisor. But here are some possible courses of action for you to consider:
- Leave your money with your old employer’s 401k plan. This can be problematic for several reasons: the investment choices are limited, the fees can be high, and you’re no longer receiving an employer match to your contributions.
- Roll your old 401k over into your new employer’s 401k plan. This can be a sensible option if the investment choices within the plan are good, and make sure the fees are reasonable.
- Cash out some or all of the account, which would require you to pay taxes & penalties if you’re younger than 59½ . This is probably not advisable, unless of course you have an immediate need for the money. Taxes and penalties make this choice unattractive – and you lose tax-advantaged growth within the account going forward.
- Roll your assets over to an Individual Retirement Account (IRA). This is usually the best option, as you avoid 401k plan fees and have a nearly unlimited list of investment choices.
6. Why a Rollover IRA is Usually a Good Idea
- Lower Fees – The first thing to consider is fees. 401k plans often charge 1.5% or more – and that does not even include the mutual fund fees for the funds within the plan. That sort of fee structure can really add up over time.Let’s say you’re 40 years old with an old 401k from a prior job with $150,000 in assets, and that plan charges an annual fee of 1.5%. Assuming a 6% compounding growth rate and a 1.5% fee, the account will be worth more than $560,000 in 30 years. But if that fee was only 0.5%, the value of your portfolio would be over $100,000 greater after that same 30 year span, almost $670,000.IRA’s don’t come with high plan fees, which is a great reason to think about a rollover. Users of Personal Capital’s free tools can use the Fee Analyzer feature to keep track of the fees they are currently paying for their investments.
- More Investment Options – The next thing to think about regarding your old 401k is the list of investments available to you. Once the money settles into your IRA, you or your financial advisor can choose among thousands of ETFs, bonds, mutual funds, and individual stocks. Your options are almost limitless. You’re no longer restricted to the short list of mutual funds that are typically offered in a 401k.
- Increased Withdrawal Flexibility – Lastly, users of both IRAs and 401ks usually incur a penalty along with the regular tax requirements if withdrawing funds before age 59½. However, the rules surrounding IRAs provide more flexibility. Under certain circumstances, you can withdraw assets from an IRA without incurring that penalty – and 401ks do not provide those opportunities. For example, qualified education expenses might not incur a penalty if withdrawn from an IRA, and up to $10,000 may be withdrawn without penalty if used toward buying your first home. So IRAs can provide easier access to your cash in some cases.
Considering all of the available options in the previous section, rolling your assets into an IRA may make the most sense for your retirement for a number of reasons.
Talk to your advisor about how your 401k is allocated, and if it makes sense to roll over those assets to an IRA. Conducting a rollover is relatively easy, and it is often the best option for those who no longer work for the company that sponsors that plan. But there can be complexities in any situation – that’s why it makes sense to speak with your advisor.
Even if you’re still working at the sponsoring firm and it makes sense to leave the assets where they are, it’s still best to talk to your advisor about how the assets are invested within that plan.
Determine if the goals and time horizon for those assets are similar to those of your other investments, and if it makes sense to invest them similarly. Regardless, always keep an eye on fees and the diversification level of your portfolio.
Here are some other steps you can take now, and for free, to help you manage and evaluate your 401k:
- Utilize free online tools like Personal Capital to analyze your retirement readiness. Personal Capital offers a tool called “Retirement Planner,” which allows you to see how likely your current portfolio and retirement plan are to be successful.
- Make sure you analyze how much you are paying in fees in your 401k.Personal Capital’s Fee Analyzer tool will help you spot any hidden or excessive fees.