With pensions a long-forgotten relic of the past, most Americans are looking at ways to save for their retirement years on their own. While many companies offer these plans, though, many employees have very little guidance when it comes to investing in their 401(k).
There can be thousands of options to choose from under some plans, but picking the right ones can be the difference between a comfortable retirement or years of extra work.
How Does a 401(k) Work?
A 401(k) is a savings account that has some specific tax advantages. They were originally established through a loophole in the US tax code in the 1980s, but several rounds of legislation have made them accessible to just about anyone.
The accounts are set up for each employee in a company. Each employee is able to put funds into the account, which may or may not be matched by their employer. Funds put into the account are not subject to federal income tax. Over several years, the money in the account has the potential to grow exponentially. This means that a series of small investments over time can lead to a large amount of money.
It’s important to note that the money in these accounts is only meant to be used for retirement expenses. In order to discourage employees from taking money out of the accounts before their retirement date, there are financial penalties that have to be paid in the form of extra taxes.
401 (k) Advantages
One of the first questions that many people have when their introduced to their company’s 401(k) is how this plan can really benefit them. There are plenty of savings accounts available, and very few of them have the restrictions that a 401(k) plan can offer.
The main advantage, of course, is the ability to save on federal income taxes. Every dollar that is put into a 401(k) account is considered non-taxable income by the federal government (up to a limit of $15,500). For people who are looking at particularly high tax burdens, this can save them thousands of dollars off of their tax bill. Furthermore, the money that is in the account is allowed to grow tax-free.
When it comes time to start withdraws of money from the account for retirement, the money is considered to be normal taxable income. Since many people are planning on having less income in retirement than they are during their working years, however, the overall tax burden accrued by the money saved in the account tends to be thousands of dollars lower.
In addition to the tax benefits, many companies offer to match a portion of the funds put into a 401(k) account. In many cases, this means that an employee can see their contributions double simply by investing enough to get the full value of the company match.
What Can I Invest In With A 401(k)?
Choosing the right investments is absolutely critical in order to make the most of your 401 (k) account. Fortunately, many accounts come with thousands of options to choose from. Possible investments include government bonds, stocks, corporate bonds, and a wide range of more exotic investments. In fact, it’s possible to invest in gold and other commodities, real estate, and more.
Deciding how to invest can be a challenge, however, and it will be necessary to reconsider your portfolio as your overall financial and personal situation changes. While there has been plenty written on the subject of investment strategies, there are a few rules that just about every financial advisor and planner agrees on.
Have a mix of investments. The more diversity in your account, the more likely it is that you will be able to survive a downturn in any one particular sector of the market. That means diversifying the type of investment and the industry. Look for a mix of stocks, bonds, cash, government securities. Within your portfolio of stocks and corporate bonds, try to diversify so that you have some exposure to energy, retail, consumer manufacturing, and other major sectors of the economy. Finally, make sure that your investments are spread out over different size companies.
Exposure to small cap, mid-cap, and blue chip stocks ensures that your money reaches just about every segment of the economy.Limit your exotic investments. There are plenty of “hot” investment ideas, but it’s a bad idea to put more than 10% of your overall portfolio into any one particular investment. Make sure that you don’t have too much money in a particular stock.
Also, limit your exposure to investments such as REITs and commodities. These investments can be extremely difficult to track, and are meant more as short-term investments.Get the right mix of investments for your situation. It’s normal for investments such as stocks to lose some value over time. If you have several decades before you will need to withdraw the funds from your account, however, these losses can be easily recovered. If you don’t have much time before you will need the funds, though, you may want to consider “safer” investments such as bonds and CDs that will not experience such drastic dives.
For this reason, many financial advisors tell their young clients to invest their portfolios mainly in stocks, but gradually convert the money to bonds and cash as they age. Avoid frequent trades. Because these funds are so important to your future, it’s hard to resist the urge to review their performance on a daily basis.
When you review your portfolio this frequently, however, it’s hard to resist the temptation to make more trades. While frequent trading of stocks might be a good hobby for people who are interested in investing, it is a poor idea for a 401(k) account. Remember that this is money that will be saved and used over nearly a century; a buy and hold strategy is usually the best one. Frequent trading often results in any profits being eaten up by fees, and can very quickly lead to severe account losses.