How to Manage Your 401k
If you derive your livelihood as a corporate employee, you’ve likely been offered retirement benefits as an incentive to join a new company, the most common of those benefits being the 401k plan. Participating in a 401k plan can be an excellent way to reduce your current taxable income and grow your money, making it almost a no-brainer for you. But because the ultimate outcome of your retirement investing depends on you, not on your employer, it can seem like a tall order if you’re not well-versed on how investing for retirement works. So, we’ve come up with 8 simple steps on how to manage your 401k that can get you started on the road to investing for retirement.
1. Take the Free Money
That’s right, participating in a 401k plan can mean receiving free money. Many employers offer matching contributions to encourage employee participation. For every dollar an employee contributes into the plan (up to a certain amount), his or her employer will match the contribution (sometimes dollar-for-dollar), essentially providing the employee with additional free money to invest. If you don’t do anything else in your 401k plan, you should at least contribute the maximum amount that your employer is willing to match. It’s not often you can enjoy an immediate dividend on your invested money.
2. Maximize Your Contribution
The money you contribute into your 401k plan generally reduces your current taxable income, which in turn, reduces your current tax liability. What this means is, the more money you contribute, the less money you’ll have to pay to the IRS in the same year. Just to be clear, you still have to pay taxes on it eventually. But by the time that money is subject to income taxes (ideally when you withdraw it during retirement), it will have grown tax-free for many years. And since your taxable income during retirement could be significantly less than your current taxable income, you may well be in a lower tax bracket.
For the year 2019, you are allowed to contribute up to $19,000 into your 401k plan, and $6,000 more if you’re 50 or older. Maximize your contribution to maximize your current and future tax savings.
3. Know Your Employer’s Vesting Schedule
In exchange for giving you free money, your employer will likely set up a vesting schedule to protect itself in case you leave the company. If you do leave the company before a certain time frame, a vesting schedule may require you to give a portion of the money back. So, before you hand in your resignation, understand your employer’s vesting schedule and know how much money you’d have to forfeit.
Remember that your own contributions to a 401k plan are always 100 percent vested by law, so the vesting schedule never applies to the money you invest from your paycheck.
4. Learn the Value of Indexing
Many 401k plans offer index funds as an investment option for your money. An index, as opposed to an individual investment, is a bundled group of pre-determined investments that you can buy very simply. For example, the S&P 500 Index is a group of the 500 largest publicly traded U.S. companies. Rather than choosing to own one or two individual stocks, which might prove to be a risky investment decision, the S&P 500 Index allows you to own 500 companies at once. (Should one company out of the 500 go out of business, you still own 499 others.) Indexing takes the pressure off of you to pick the right companies to invest in.
Indexing can also lower your trading costs. Talk with your financial advisor if you have any questions about how this effects your situation and how to manage your 401k.
You will likely be offered additional investment choices beyond an index fund, and these are worth considering. But if you worry you have little time to devote to researching the various investment choices, an index fund investment can be a good choice in the long run.
5. Reduce Your Investment Risk Over Time
The two biggest investment classes that will be available to you in your 401k plan are stocks and bonds. When you buy stocks, you own shares of companies, and when you own bonds, you’re lending money to those companies. Stocks are riskier to own, but they generally give you a higher return over the long-run.
If you’re still years (or decades) away from retirement, it can make very good sense to own stocks, even though this entails more risk in the short-term. As you get closer to retirement age, you’ll want to talk with your financial advisor about whether to reduce or eliminate those risks.
6. Play the Long Game
Throughout your career, there are bound to be ups and downs in the stock market. As long as the stock market is open, short-term fluctuations will always happen.
It’s no fun seeing your investment portfolio decrease in value during a recession, but it’s even worse to sell your investments at their low points in a moment of panic. A good way to take your emotions out of the equation is through dollar-cost averaging, where you invest a set amount of money at set intervals. Retirement investing by definition is investing in the long run, so play the long game and don’t let your emotions take control at the worst possible time.
7. Understand the Penalties of Early Withdraw
Once you put money into your 401k, you generally can’t remove it without suffering penalties until you reach 59-½ years old. Taking early withdrawals can subject you to penalties and increase the amount of money you owe in taxes. An early withdrawal can end up being a very costly decision. Again, discuss your options with a financial advisor before making any rash decisions.
There are some exceptions to the penalty, such as certain hardship withdrawals and loans against your account when you’re buying your first home. But even in those exception cases, you may still lose the tax-free growth of your plan contributions. In general, you should treat your 401k as money locked away until you retire to receive the maximum tax benefit.
8. Talk to a Fiduciary Financial Advisor
If you need someone to guide you through your 401k investment plan, know that help is available. There are plenty of knowledgeable investment professionals who can not only walk you through the steps of how to manage your 401k but also may be able to assist by doing the investing for you. A financial advisor can help you choose the right investment options, allocate appropriately for your specific situation and guide you through your tax savings. But make sure you’re working with a fiduciary financial advisor, who, by law, must put your best interest first.
How to manage your 401k can be complicated, but whatever you do, don’t forgo this benefit. Your future self will thank you for it.