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Congratulations! You have a job that offers you a 401(k) account. Clearly, you should participate, to enjoy some tax savings as you save for retirement. But don’t just leave it all up to chance, letting your employer sign you up for default-level contributions to default investments.
Here are three smart strategies to help you make the most of your 401(k) account.
Image source: Getty Images.
No. 1: Save aggressively
By default, your employer might start you out contributing a relatively small percentage of your salary to your account — or it might not automatically enroll you at all. Don’t settle for that. Odds are, you’re behind in your savings for retirement, and default settings won’t improve that situation much. Even saving the oft-recommended 10% of your savings may not be enough.
Contribution limits for 401(k)s are generous, set at $19,500 for 2020, with an extra $6,500 allowed for those 50 and older, for a possible total of $26,000. So consider socking away a lot in your 401(k) plan (unless it’s a bad 401(k) plan with high fees and poor investment offerings).
If your plan isn’t the best and/or you have other retirement savings accounts, you might not put too much in your 401(k) — but be sure to sock away at least enough to grab all available matching contributions from your employer. Many, for example, match all or half of your contributions up to 3% to 6% or so of your salary.
No. 2: Invest effectively
Next, be sure to invest the money in your 401(k) account effectively. Companies will often park employee contributions in certain investments by default, with employees responsible for choosing other options. Default investments may be extra-conservative, and many times they’re target-date funds.
Each target-date fund is designed to serve shareholders who are retiring in a specified year, and over time, as that year approaches, the fund shifts its asset mix, shrinking its exposure to stocks and increasing its exposure to bonds. That’s fine, but look closely, because you might want a more aggressive mix or a more conservative one. For example, the Vanguard Target Retirement 2040 fund recently had about 81% of its assets in stocks, 16% in bonds, and a few percentage points in cash. If you plan to retire around 2040 but would like to be invested 90% or more in stocks, you might switch your contributions to Vanguard’s 2050 target-date fund, even though you’re looking at a 2040 retirement.
For many, if not most, of us, it’s hard to beat a low-fee, broad-market stock index fund for much or all of your long-term money. There’s a good chance your plan offers one, and if it doesn’t, you might let your plan administrator know that you’d like one. Even Warren Buffett thinks highly of index funds.
Consider opting for a Roth 401(k) account (as opposed to a traditional one), too, if your employer offers it. Just as with IRAs, while a traditional account offers a front-end tax break, reducing your taxable income by the amount of your contribution, the Roth version accepts post-tax dollars and offers a back-end tax break. If you follow the rules, your withdrawals can be entirely tax-free.
No. 3: Stay the course
Finally, be sure to stay the course. Great wealth can be accumulated via 401(k) accounts, but only if you contribute aggressively and invest effectively. The table below will give you an idea of what you might amass:
|
Growing at 8% for |
$10,000 invested annually |
$15,000 invested annually |
$20,000 invested annually |
|---|---|---|---|
|
5 years |
$63,359 |
$95,039 |
$126,718 |
|
10 years |
$156,455 |
$234,683 |
$312,910 |
|
15 years |
$293,243 |
$439,865 |
$586,486 |
|
20 years |
$494,229 |
$741,344 |
$988,458 |
|
25 years |
$789,544 |
$1,184,316 |
$1,579,088 |
|
30 years |
$1,223,459 |
$1,835,189 |
$2,446,918 |
Data source: Calculations by author.
Many people cash out their accounts when they change jobs, and that can severely threaten their future financial security. If you’re withdrawing, say, $40,000, thinking it’s not such a meaningful sum, understand that if you’re still 25 years from retirement, that sum could grow to more than $273,000 if it averages 8% annual growth and more than $443,000 if it grows at 10%.
So don’t cash out your account, and don’t borrow from it, either. If you change jobs, look into rolling your account over to your new employer’s 401(k) plan, or just roll it over into an IRA.
For most of us, Social Security will not provide nearly enough income in retirement, so we should be saving and investing for retirement on our own. Making good use of a 401(k) account can be a great help in your retirement savings.
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