What to Know Before Investing in a 401(K)

investing in a 401 k, how to invest in a 401 k

In the good ole days, before investing in a 401(k) became prevalent, employees participated in defined benefit (DB) plans. These plans typically guaranteed lifetime payments, calculated by multiplying years of service by a percentage of average salary during the final years of their employment.

DB plans are no longer the norm. While almost 60% of Americans had DB plans in the 1980s, only 14% have them today.

DB vs. DC Plans

How DB plans worked

DB plans were predictable.  Participants knew that, if they worked long enough and achieved a salary that increased over time, they could count on a fixed payment over their life and often over the life of their spouse.

DB participants didn’t have to do anything more to qualify for their benefit.  The amount of their benefit didn’t depend on stock market returns. Participants had no role in selecting investments in the plan.

Generally, making contributions to a DB plan was the responsibility of the employer, although some plans required employees to contribute.

What Are DC Plans?

Defined contribution (DC) plans are tax-deferred retirement plans wherein employees make regular contributions to an account that funds their retirement. They contribute a fixed amount or a percentage of their paychecks, while employers can match a portion of the contributions as an added benefit.

DC plans have largely replaced DB plans.  The most common DC plan is a 401(k) plan.

DC plans shift the onus from the employer to the employee.

There is no promise of specific benefits in retirement.  The employee decides whether and, if so, how much to contribute to the plan.  The employee also must select investments, often from many choices.

The employer may match the employee’s contributions up to a certain percentage of salary. 

A DC plan requires participants to take primary responsibility for managing the plan.

DC plans are now the dominant source of retirement savings for many Americans. 

How to Manage Your 401(k) Plan

how to manage your 401 k plan

Given the importance of DC plans, it’s critical that employees educate themselves and manage their plans in a way that optimizes retirement benefits.

Here are some tips for doing that.

1. Make an informed enrollment decision

Enrolling in a 401(k) plan is not a no-brainer.

You will be tying up your money until you reach 59 ½, unless you pay substantial penalties.  If you need funds for a large purchase in the near term (like a down payment on a home or an automobile), you should defer contributing to a 401(k) plan.

While the earnings on your investments will grow tax-free, it’s not a free ride forever.  When you withdraw your money, you’ll be taxed on your earnings at your marginal tax rate at the time. No one can predict what that rate will be.

If you have significant debt, especially if it’s high interest credit card (or similar) debt, it might be prudent to pay off that debt before contributing to a 401(k) plan.

If you don’t have an emergency fund with 6-12 months of expenses, you might want to build that fund up before contributing to a 401(k) plan.

If others depend on your income, you should first have adequate life and disability insurance in place.

2. Know the reasons to contribute to a 401(k)

Some employers “match” your 401(k) contribution based on a percentage of your contribution, up to a limit of your total compensation.  It’s quite common for employers to match 50% of your contribution, up to a maximum of 6% of your salary.

If you don’t invest the minimum required to receive the maximum employer match, you are losing out on “free money.” 

Here are some other reasons to invest in a 401(k):

  • It’s an easy way to automate your savings.
  • Your contributions are tax deductible and your earnings grow tax deferred.
  • You benefit from the “miracle of compounding.”
  • Over time, you benefit from dollar cost averaging.
  • You should have funds available to you in retirement that will supplement Social Security.

3. Invest in a 401(k)

If you have decided to participate in your 401(k) plan, the next decision you’ll need to make is how to invest your money, using the investment options available in your plan.

Here are some tips on how to invest in a 401(k).

  • Focus on what matters

Much of the financial media is focused on picking stock “winners,” predicting the direction of the market, or trying to find the next “hot” mutual fund manager.

Don’t follow their lead.

Your focus should be on asset allocation (the division of your portfolio between stocks, bonds and cash) and holding a broadly diversified portfolio.  Both are critical tools in managing investment risk.

  • Look out for fees

Be aware of the pernicious impact management (and other) fees have on your returns.  According to the Securities and Exchange Commission, even fees which seem small can significantly impact your portfolio.

Generally, index funds, exchange traded funds and passively managed funds have lower management fees than actively managed funds.

  • Keep it simple

For some investors, one low fee, broadly diversified index fund (like a target date retirement fund) might be the only holding you need in your 401(k) plan.

investing in a 401(k)

With proper education and prudent investing, you can turn your 401(k) plan into a fund that will serve you well in retirement.