Understanding 401(K) Investment: Timing Your Retirement Savings

A 401(k) is a tax-advantaged retirement savings plan, allowing employees to contribute a percentage of their income. There are two types: traditional and Roth. With a traditional 401(k), contributions are pre-tax, reducing taxable income, but withdrawals are taxed. With a Roth 401(k), contributions are made with after-tax income, so there's no immediate tax break, but withdrawals are tax-free.

Once you've decided on the type of 401(k) you want, you need to choose your investments. Most 401(k) plans offer a range of funds, from conservative to aggressive. You can choose to spread your money across several funds, but you should consider your risk tolerance, age, and how much you'll need to retire. It's recommended to diversify your investments to mitigate risk.

You should also be mindful of fees. Actively-managed funds, which hire analysts to conduct securities research, tend to have higher management fees. Index funds, on the other hand, require little to no hands-on management and have lower fees.

Understanding 401(k)s

A 401(k) is a tax-advantaged retirement investment account offered by employers in the US. It is a "defined-contribution plan", meaning that employers may match employee contributions, with some plans making this mandatory. There are two main types of 401(k)s: traditional and Roth.

Traditional 401(k)s

Employee contributions to traditional 401(k)s are made pre-tax, reducing taxable income. However, withdrawals made during retirement are taxed.

Roth 401(k)s

These are offered by fewer employers than traditional 401(k)s. Contributions are made with after-tax income, so no tax deduction is made in the contribution year. However, withdrawals made during retirement are tax-free.

How to Invest in a 401(k)

K)s tend to have a small investment selection curated by the plan provider and employer. You can't usually invest in individual companies, but instead, you select mutual funds or exchange-traded funds (ETFs) that invest in a variety of companies and sectors.

When choosing investments, you should consider long-term returns and expense ratios (the fees carried by investments). You should also assess your risk tolerance and time horizon. If you're in your 20s or 30s, for example, you may want a higher allocation of stocks, whereas someone closer to retirement might prefer a target-date fund, which automatically adjusts the asset mix to align with a preset retirement date.

Withdrawing from a 401(k)

Withdrawing money from a 401(k) before the age of 59 1/2 will usually incur a 10% early withdrawal penalty and income tax on the distributions. There are some exceptions to this rule, including becoming disabled, unreimbursed medical expenses, and economic losses due to a federally declared disaster.

Choosing investments

When it comes to choosing investments for your 401(k), there are several key factors to consider. Here are some guidelines to help you make informed decisions:

• Understand your risk tolerance: Assess how much risk you are comfortable with. If you have a high risk tolerance, you may be willing to invest in more aggressive options, while those with a lower risk tolerance may prefer more conservative choices.
• Diversify your portfolio: Diversification is crucial to balance risk and maximize returns. Spread your investments across different types of assets, such as stocks, bonds, and mutual funds. Diversification can help minimize risk and potentially increase long-term returns.
• Consider your time horizon: If you are in your 20s or 30s, you may want to take on more risk by investing a larger portion of your portfolio in stocks. As you get closer to retirement, consider gradually reducing your stock allocation and shifting towards more conservative investments to lower your risks.
• Evaluate fund performance and costs: Look at the long-term returns of the investment funds offered in your 401(k) plan. Consider both five- and ten-year returns, as well as returns since the fund's inception. Also, pay attention to the expense ratios, which represent the annual fees associated with each fund. Generally, look for funds with strong returns and low expense ratios.
• Utilize target-date funds: If you don't want to actively manage your investments, consider target-date funds. These funds automatically adjust their asset allocation based on your chosen retirement date, becoming more conservative as you approach retirement.
• Seek professional guidance: If you feel overwhelmed or unsure about choosing investments, consider seeking advice from a financial advisor or using a robo-advisor service. They can provide personalized recommendations based on your financial goals, risk tolerance, and time horizon.
• Monitor and rebalance your portfolio: Once you've made your investment selections, regularly review the performance of your investments. Over time, the allocation of your portfolio may drift from your original plan due to varying returns. Periodically rebalance your portfolio to ensure it aligns with your desired asset allocation and risk level.

Risk tolerance

Understanding Risk Tolerance

Factors Affecting Risk Tolerance

Several factors can influence an individual's risk tolerance. These include age, financial goals, and personal temperament. Younger investors, for example, often have a higher risk tolerance because they have more time to recover from potential losses. On the other hand, older investors nearing retirement may have a lower risk tolerance as they seek to preserve their savings.

Determining Your Risk Tolerance

To determine your risk tolerance, it's important to assess your financial situation, goals, and comfort level with market volatility. Consider how you would react if your investments declined in value due to market fluctuations. If you feel anxious or uncomfortable, you may have a lower risk tolerance. Conversely, if you are excited by the potential for higher returns and can handle market ups and downs, you may have a higher risk tolerance.

Your risk tolerance will guide the types of investments you choose within your 401(k) plan. If you have a higher risk tolerance, you may opt for more aggressive investment options, such as stock funds. These investments offer the potential for higher returns but also come with greater risk. On the other hand, if you have a lower risk tolerance, you may prefer more conservative options, such as bond funds or money market funds, which are less volatile but typically provide lower returns.

Adjusting Your Risk Tolerance Over Time

It's important to note that your risk tolerance may change over time as your financial situation and goals evolve. For example, as you get closer to retirement, you may want to adjust your investment strategy to become more conservative, reducing your exposure to riskier assets. Regularly reviewing and reevaluating your risk tolerance can help ensure that your investment strategy remains aligned with your financial goals and comfort level.

Asset allocation

As a rule of thumb, you can subtract your age from 110 or 100 to find the percentage of your portfolio that should be invested in stocks; the rest should be in bonds. Using 110 will lead to a more aggressive portfolio, while 100 will skew more conservative.

However, this rule of thumb doesn't consider other factors, such as your risk tolerance. If you're the type of person to jump ship when the market gets rocky, you may want to take on less risk. If you live for that kind of thrill, you might take on more.

• Your age: The younger you are, the more you can afford to invest in riskier stocks. You'll also have more time to recoup any losses. As you get older, you should gradually reduce your holdings in riskier funds and move to safer investments.
• Your financial goals: How much money will you need in retirement? You can use a retirement calculator to help you figure this out.
• Your risk tolerance: How do you feel about taking risks with your investments? Are you comfortable with the possibility of losing money in exchange for higher potential returns, or would you prefer safer investments with lower returns?
• Fees: Different funds charge different fees, which can eat into your returns over time. Index funds, which track a stock index like the S&P 500, tend to have lower fees because they require less management by professionals.
• Diversification: It's generally a good idea to spread your investments across different sectors and types of assets to reduce the risk of a downturn in any one asset class.

Once you've decided on your asset allocation, it's important to review and rebalance your portfolio periodically to make sure it still aligns with your financial goals and risk tolerance.

Costs and returns

There are three basic categories of 401(k) fees: investment fees, plan administration fees, and individual service fees. These fees can be listed on a plan administrator's website, within marketing materials, in a fund's prospectus, or elsewhere.

Investment Fees

Investment fees may account for the largest portion of 401(k) fees and often come from the cost of investment-related services levied by the funds in your 401(k). Investment fees are usually charged as a percentage of assets invested and can be broken down into sales loads, expense ratios, and other additional costs. For example, a 1% fee would charge you 1% of your current assets in that fund every year.

Plan Administration Fees

When you have a financial institution managing your 401(k), there will be administration fees. Charged by the 401(k) provider, these fees cover general management, legal and trustee services, record-keeping, and accounting. They also include day-to-day operations of the financial institution like customer service representatives, electronic access to plan information, and educational seminars.

Individual Service Fees

Individual service fees cover extra plan features that you choose to opt into. Some of these extra features include distribution services, rolling over 401(k) investments, taking out a loan, and QDROs (dividing up assets during divorce). These fees can range anywhere from $20 to over $150, depending on the type.

The fees aren't actually hidden, but they are disclosed in the prospectus that is given to new investors when they enroll in a plan. This prospectus is updated yearly, reflecting any change in fees. Disclosing fees is not optional but is a requirement of the U.S. Department of Labor. To check fees, look through your 401(k) statement or prospectus for line items such as Total Asset-Based Fees, Total Operating Expenses As a %, and Expense Ratios.

According to the U.S. Department of Labor, say you start with a 401(k) balance of $25,000 that generates a 7% average annual return over the next 35 years. If you pay 0.5% in annual fees and expenses, your account will grow to $227,000. However, increase the fees and expenses to 1.5%, and you'll end up with only $163,000—effectively handing over an additional $64,000 to pay administrators and investment companies.

It's important to be aware that you can't avoid all the fees and costs associated with your 401(k) plan. They are determined by the deal your employer made with the financial services company that manages the plan.

Among your choices, avoid funds that charge the biggest management fees and sales charges. Actively managed funds are those that hire analysts to conduct securities research. This research is expensive and drives up management fees. Index funds generally have the lowest fees because they require little or no hands-on management by a professional. These funds are automatically invested in shares of the companies that make up a stock index, like the S&P 500 or the Russell 2000, and change only when those indexes change. If you opt for well-run index funds, you should look to pay no more than 0.25% in annual fees. By comparison, a relatively frugal actively managed fund could charge you 1% a year.

Expense ratios are the fees carried by investments, and they range widely. They're charged as a percentage of the amount invested. You might find your 401(k) offers only one choice in some categories, but when you have a selection, you should generally pick the lowest-cost option—often an index fund. Even small differences in fees can have a huge effect over time. Say you've invested $100,000 at a 7% annual return: A fund with a 0.80% expense ratio could eat up $70,000 more of your returns over 30 years than a fund with a 0.40% expense ratio.

Frequently asked questions