Understanding Your 401KDecember 14, 2015
Does the thought of manually setting up your 401k make your palms sweat? In today’s episode, we break down some of the complexities of the traditional 401k plan to give you the confidence to make the best of your retirement savings.
What exactly is a 401k?
The 401k is a retirement savings plan provided through your employer. Money you contribute is often done as a percentage of your gross income and goes in before-tax. From there, it gets invested in mutual funds and can be withdrawn when you turn 59 1/2. When you withdraw this money, it then gets taxed based on your income tax rate at that age.
Side note – it’s called a 401k because the rules are explained in section 401-k in the tax code.
Sometimes, your employer will offer to “match” your contributions up to a certain percentage of your gross income. This number could often be around 3%-5%. Using 3% as an example, if you only contribute 2%, then your employer will only contribute 2% as well. It’s highly recommended that you at least contribute up to the maximum matching provided by your employer.
How do my contributions get invested?
That’s up to you! Often, a financial advisor will direct you on how you should allocate your money, but it’s important that you understand where your money is going throughout the process.
It’s important to know that advisors will often place your money into funds that charge very high investment fees. Even a fee of only 2% can eat up almost 50% of your investment earnings over the course of your retirement saving.
To cut down on the fees, the best route is often in picking low-fee funds. In general, funds that are passively managed incur the lowest fees (often less than 1%). These are typically known as Index Funds, and most employer 401k plans offer Index Fund investment choices.
Which funds should I choose?
Now that we know that we should first investigate Index Funds if available, the next question is how exactly we choose to allocate our money over these funds. You might want to avoid putting 100% of your money into a single fund, as it’s possible that doing so won’t be an adequate investment diversification.
When looking into your investment choices, you might notice several of these key phrases:
- Large Cap – a collection of stocks composed of some of the largest companies in the market
- Small Cap – a collection of stocks from smaller companies in the market. Since the companies that make up this collection are less established, they involve higher risk along with a higher potential return
- Bond, International – self explanatory. Comprised of a large portion of bonds or international stocks, respectively
There are many ways to divide up your investments throughout these various fund types, and in general, you should consult an investment professional to pick the proper allocation for your risk level.
For what it’s worth, I go with the following allocation (all low-fee Index Funds):
- Large Cap: 30%
- Mid Cap: 25%
- International: 20%
- Small Cap: 15%
- Bond: 10%
This is essentially a 90/10 stock/bond mix, which I find to be suitable based on my age.
In general, stocks offer higher risk/higher returns and bonds offer lower risk/lower returns. There are also those that recommend that you go with a bond allocation equal to your age (e.g. if you’re 25 years old, go with 75/25 stock/bond mix), however, I find this to be a bit too conservative.
Where can I learn more?
We highly recommend the following books for learning more about setting up your 401k (and investing in general):
- The Truth About Retirement Plans and IRAs by Ric Edelman
- The Four Pillars of Investing by William J. Bernstein