Your workplace 401(k)s are employer-sponsored retirement accounts that allow employees to assign a portion of their pre-tax salary into that account. Employers can match your contribution to a specific limit, but this needs to be checked individually as each company can have different ways in which they approach this.
Once the contribution is assigned to your retirement account, the funds wait patiently for you to invest so that your retirement plan increases the returns. A 401(k) plan is the way in which the retirement account is managed. The easiest way to describe it is by saying that you make your money work for you to increase your profit. Increasing your profit requires investments that you can choose from and are managed by financial institutions. This is where diversification comes into play, but we’ll get on that immediately. Let’s see how one should pick investments for 401(k)s in 2021.
Before you decide what you invest in - bonds, stock, commodities, or others - you should understand some factors related to investments. The most important of these is the risk factor. As it’s the most personal factor for investments, only you can decide how much risk you are willing to take. This plays a vital role in the type of investment you are making, the contribution you intend to make, and the financial stability you’ll have once the decision is made.
Your age is the second most important factor, or, better said, how far you are from retiring. Many think that they still have time to make these decisions later on, but the sooner you invest in your 401(k)s, the larger your returns would be. For younger people, riskier investments are more accessible as they have fewer responsibilities and an easier way to handle difficult situations. When you’re in your mid-20s, chances are you don’t have a family to sustain, but when you’re in your 40s, there is a house, a spouse, a couple of children, and far more responsibilities. The risks may be bigger, but so are the payoffs. As years go by, high-risk investments should decrease as retirement approaches.
The last factor to consider is the sum needed after retirement. Financial advisors recommend savings that would provide for 80% of your income prior to retirement. The funds can come from different sources, including 401(k)s, social security, or other pension plans. Most, if not all, financial institutions provide interactive retirement calculating tools for a more comprehensive approach that allows you to apply different assumptions to see which will get you closer to the sum required after retirement. Another option would be to multiply your pre-retirement income by 12.
As we already mentioned diversification, the reason why it’s so important is that it’s always better to spread your investments across several investment methods. Using one investment source is risky because if something happens, you might lose all your funds. However, diversification provides returns from several types of investments - bonds, stocks, commodities, or others - without risking a downturn in any one kind of investment.
The potential downside to this is the temptation to micromanage your investments depending on how the market moves. Company stocks can also increase your investment risk level, and financial advisors say that 10% should be your portfolio limit in them.
While your workplace deals with the financial service company that will manage your 401(k)plan, you are informed about the fees applied to your 401(k). This means that when you discuss how your 401(k) should be managed, you can make informed decisions based on the expenses that come from it. There are two types of bills generated by a 401(k) plan: the plan expenses - unavoidable - and the fund fees - determined by the investment you choose.
If the type of investment you chose requires active management from financial analysts conducting security searches, the fund fees or management fees will be higher. However, index funds have the lowest fees as they barely require any hands-on management from a financial analyst. An index fund should not have more than a 0.25% annual fee and an actively-managed fund can charge a 1% annual fee or more.
A 401(k) plan might not seem like a priority during the first stage of employment; however, combining the potential employer match and the tax benefit with it makes it difficult to resist. The value of your investment can be the minimum payment required for your 401(k) plan for your employer to match your contribution. The fact that you are also reducing the federal taxable income by the value you contribute to the plan is an added benefit.
It is important to note that for 2020 and 2021, your contribution to your 401(k) plan can go up to $19,500 of pre-tax income, and people over 50 years of age can add $6,500 more.
While the usual tax benefits promote 401(k)s to the most popular employer-sponsored retirement plan, there are extra benefits for low-income employees called saver’s tax credit. This raises the refund and reduces the owed tax for people with lower incomes by offsetting up to 50% of the first $2,000 assigned to their 401(k) or other retirement plans. The percentage offset depends on the taxpayer’s annual adjusted gross income.
Monitoring your 401(k)’s performance can motivate you to rebalance your portfolio in such a way that you move investments into slower-growing investments from faster-growing investments. The reason why this is suggested is the fact that you made the plan based on a financial goal and leaving it alone. If one investment performs much better than another, it will skew your asset allocation, and if that happens, your balance may be at risk for a crash in that particular investment. If this occurs when your portfolio is balanced, the loss isn’t as drastic, but if a crash occurs when your portfolio is off-balance, the loss can be more significant.
Keeping your hands on the asset is another critical factor. Borrowing from your 401(k), aside from the tax benefits being nullified, you will also decrease your portfolio. Repaying yourself with interest may seem like a good idea, but allowing your long-term investments to play out without interruptions is a far better strategy.
Changing jobs is a reality of life whether we want it or not. Cashing out your 401(k) when this happens is a flawed strategy because most of us change jobs around six times during our life. Cashing it out every time this happens will leave nothing for retirement, and a 401(k) works best after retirement. Add to this the tax you’ll pay for an early withdrawal. If you change your job after you started your 401(k), you may be able to roll over your money through a direct transfer to your new employer. The transfer can be made between your old company’s 401(k) to the IRA or towards the new employer’s 401(k).
Savings are the best way towards retirement or financial independence, and planning for it is ideal. Deciding whether to invest in your 401(k) or pay off your house depends on your golden years’ plan. You can start investing in your retirement account from the start of your employment contract because the “pay yourself first” method might be the best for you. A 401(k) allows you not only to save money but to invest it as well and increase your retirement funds. The best thing is that you’ll be able to watch the process and evaluate its performance as it happens.