If you have one available to you, your 401(k) can easily become the cornerstone of your retirement plan. People under 50 can generally contribute up to $19,500 per year to their plan, while those 50 or up can sock away as much as $26,000. When the maximum allowed employer contributions are included in the mix, those limits jump to $57,000 and $63,500, respectively. That’s some serious cash that you and your boss can invest in a tax-advantaged account on your behalf to help fund your retirement.
That large potential contribution amount, along with the tax advantages associated with having money in that type of account, should put your 401(k) high on your list when it comes to your own planning. Still, just having a 401(k) available isn’t enough. You need to know how to leverage it effectively to build your nest egg. These six are among the best investment strategies for a 401(k) available to many participants.
No. 1: Contribute at least enough to max out your match
Frequently, employer contributions to 401(k) plans come in the form of a match – such as “50% of the first 6% of your salary that you contribute.” For you to get that matched contribution, you first must put your own money in your account. A 401(k) match typically represents the best return on investment available to us mere mortals, as it’s a high percentage increase in your account value for the simple act of depositing your own money.
As a result, investing at least enough to get your 401(k) match is often recommended as the very first investment choice for anyone just starting out on their investing journey. It is by far the best strategy you can have when it comes to leveraging your 401(k).
No. 2: Set your contributions as a percentage of your salary
There are two general ways 401(k) plans allow people to manage their contributions — either as a specific dollar amount per paycheck or as a percentage of their salaries. If you have the option to enter your contribution based on a percentage of your salary, use that as how you instruct the plan administrator to withdraw from your paycheck.
The key reason to set your contribution up that way is that it makes increasing your contribution automatic as your salary increases. That way, it’s one less thing you need to worry about when you do get a raise. It also means you’ll increase the amount you sock away each paycheck as that paycheck grows, which can help you reach your retirement goals that much faster.
No. 3: Avoid buying your employer’s stock
Some company 401(k) plans offer the option to buy the employer’s stock. Don’t. Even if your employer is a great place to work and ultimately turns out to be an awesome investment, buying your employer’s stock inside your 401(k) is one of the worst mistakes you can make. If the company runs into trouble, that can cause you to lose both your job and your retirement nest egg at the same time.
That said, if your employer offers you stock, options, stock appreciation rights, or some other form of compensation tied to the company’s shares, go ahead and accept it. Also, if your employer’s stock is one you’d own even if you didn’t work there, it’s OK to consider an appropriately sized portfolio position in it similar to what you’d have as an outside investor. Just recognize the unique risks of having your retirement and your employment tied up in the same company and prepare accordingly.
No. 4: Invest based on the time until you need the money
Over the long haul, the stock market has historically been a wonderful place to build wealth, but stocks are also very volatile investments that can move up and down rapidly. That makes stocks a terrible place to park money that you need to spend in the near term – say, within the next five years. As a result, you should consider the time frame until you need the money as a key priority in determining how you invest it.
For money you’re socking away for long-term wealth-building purposes, consider broad stock market type index funds. Those funds generally have low internal costs and low churn, and they tend to beat the vast majority of professionally managed funds. Having your paycheck contributions automatically buy those types of investments is one of the easiest ways to give yourself a strong chance of building wealth over time.
As you get closer to retirement age and approach the time when you’ll need to spend the money, it’s time to shift gears for some of your investments. Cash, CDs, money market funds, short-term Treasuries, or duration-matched investment-grade bonds are much more appropriate assets than stocks for those nearer-term needs. You will give up the potential for higher returns, but what you’re picking up in exchange is a higher certainty that the money you need will be there when you need it.
The key thing to remember here is that even once you retire, you’re likely to have a long-term future ahead of you. As a result, even retirees will need to consider holding stock-based investments for those longer-term needs.
No. 5: Revisit your plan and consider adjustments at least once a year
One of the best features of 401(k) style plans is that they automatically take money directly from your paycheck and invest it on your behalf. That can be an awesome way to build wealth, but it also doesn’t automatically change as your life and career circumstances change. Make a repeating appointment on your calendar to check in on your 401(k) at least once a year, and consider making adjustments as the rest of your life changes.
In addition, consider making changes as you reach key milestones in your life and career. If you get a big raise, consider upping the percentage of your salary that goes toward your 401(k) contribution. If you pay off your student loans, consider shifting the money you had been spending there to instead build wealth on your behalf. When you hit key milestone birthdays (like age 50) or your kids become able to care for themselves on their own, those are also great times to revisit your plan and make adjustments.
No. 6: Don’t let the tax tail wag the investing dog
There are two types of 401(k)-style plans available: traditional and Roth. Both offer tax-deferred compounding on money in the plan, and both let you contribute directly from your paycheck. The key way they differ is in the tax treatments of contributions and withdrawals.
In traditional-style plans, your money gets contributed pre-tax, but you pay ordinary income taxes on qualified retirement withdrawals. In Roth-style plans, your money gets contributed after-tax, but you pay no income taxes on qualified retirement withdrawals.
There are pros and cons to each approach, and which will ultimately work out best for you depends on several factors that you won’t really know until you hit retirement. Key among them are what tax rates will be in the future, how large your 401(k) balance will grow to, and what additional sources of retirement income you will have. In addition, what you do with any tax savings from making a traditional contribution versus a Roth contribution also plays a role.
As a general rule, you’d prioritize Roth contributions if you expect to build a big 401(k) balance, if you expect tax rates to rise, or if you expect to have significant other sources of income in retirement. On the flip side, if you plan to invest the tax savings from making a traditional-style 401(k) investment into an after-tax investment account, it can help you build up your after-tax savings balance. That can be useful if you plan to retire earlier than you’ll be able to make qualified retirement withdrawals from your plan.
While it’s OK to consider the tax consequences of picking one type of plan over the other, the reality is that it matters much less than the act of contributing a decent amount to your plan. With the median household savings for people approaching retirement age around $107,000 and even retirement-aged boomers coming up short, the most important thing is to start building your nest egg.
Pick a type, start contributing to it, and if you change your mind later, it’s OK to switch your future contributions. If the downside of picking wrong is a huge tax bill some time down the road when you retire because you have an untaxed multimillion-dollar nest egg, that’s a “first-world problem” to be sure. Don’t let that worry get in the way of the simple steps it takes to put yourself on the path to potentially build that nest egg in the first place.
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Your 401(k) can be the cornerstone of a strong retirement plan. To make that plan a reality, the most important thing you can do is get started on your investment path as soon as you reasonably can. The sooner you start, the more time will be your ally, and the better your chances will be of reaching a financially comfortable retirement.
