Your 401(k) is the most powerful tool you have to set yourself up for retirement. This is why one of the most important things you can do is to maximize your 401(k) to make sure that your money is working as hard for you as it can.
After all, 42% of Americans have less than $10,000 saved for retirement. And the average retirement savings for all families where someone is between 32 and 61 years old and is earning a salary is only $95,776.
This may sound like a lot of savings, but it means that if you survive off $30,000 per year, you’ll be broke after just over three years of retirement.
This is clearly not ideal. And you should be doing everything you can to avoid it.
Fortunately, having a strong 401(k) is the best way for you to do so.
So read on to find out just how you can maximize your 401(k) to reap the benefits that this type of account can offer.
What’s a 401(k)?
Simply put, a 401(k) is a retirement savings account that’s offered through your employer.
You choose to allocate a certain amount from each paycheck into this account, which is invested however you decide – usually a mix of stocks and bonds.
The aim is that, by the time you retire, the money in your 401(k) will have grown based on the investments you’ve chosen so that you can use that to fund your retirement.
What are the benefits of a 401(k)?
One of the great parts of investing through a 401(k) is that the money you put in there isn’t taxed until you withdraw it, which should be when you retire.
At that point, it’s likely that you’ll be in a lower tax bracket because your income will be less than it was when you earned the money originally.
This means that you’ll pay less tax on the money that you allocate to your 401(k) than you would if you simply put it into a normal account – which means more money for you at the end of the day.
However, one of the best perks of a 401(k) is that your employer may offer to match a portion of your 401(k) contributions.
Let’s be clear: this is free money and you’d be crazy not to take advantage of this as much as possible.
Say you earn $50,000 per year and your employer offers to match up to 10% of your total salary. This means that you can (and should!) put in up to $5,000 and your employer will also put in $5,000.
If you only allocate $3,000 to your 401(k), your employer will also only put in $3,000. Alternatively, if you allocate $10,000, your employer’s contributions will be capped at $5,000.
Whatever the limit, the contribution from your employer is IN ADDITION to your normal salary. Meaning that this is 100% free money and you should do everything you can to contribute up to the matching limit.
How do you know if you’ve done the right things to maximize your 401(k)?
This is a great thing to check from time to time.
From the moment you start working until when you retire, there are a range of mistakes you can (accidentally!) make with your account without even realising it. These can include:
- Excessively high fees. You may think that “1.5% per year” sounds like a good deal but if your account earns returns of 5% in one year, that’s almost one third of your returns being taken by management fees. In fact, a 2014 report found that high fees can reduce someone’s balance at retirement by 20% or more.
- Incorrect mix of stocks and bonds. We discuss this a bit further below, but let’s be honest upfront: this one can be a little tough to get right. The main problem that most people have is that they’re far too conservative for their age. This results in them losing literally tens of thousands of dollars. After all, if you still have 20 years left until retirement, you have enough time to ride a few waves in the market. So you can probably afford to be a bit more aggressive and take advantage of the better returns that this offers to you.
- Not managing your 401(k) correctly. Again, this is a bit tricky. We’ll go through various 401(k) options below, but it’s ok if you read them and still find yourself wondering: “OK, that makes sense, but which one is right for me?” And, of course, once you’ve made a choice, you then have another issue – what do you do with your 401(k) each year to make sure that you continue earning as much as possible?
Luckily, there’s a FREE tool that can do a check-up on your 401(k) for you.
Blooom will run an analysis of your 401(k) against 25,000 other funds and will let you know just how yours is going.
Importantly, it will tell you:
- If your account has any hidden investment fees that are eating away at your retirement funds
- If you have the right amount of stocks and bonds
- How to reduce any risks in your 401(k)
- Whether you’re being either too aggressive or too conservative
And, of course, it will suggest just how you can fix these things to make sure that you’re earning as much as possible for your retirement!
My favourite part of this analysis – besides the fact that it doesn’t cost anything – is that the information it provides you after its looked at your account isn’t super technical and doesn’t require an expert level of financial knowledge. Instead, it’s really easy to understand and implement.
Blooom states that, on average, its users cut their 401(k) management fees by 44% and that around one third of users had accounts that were too conservative, meaning that they were losing money over time due to lower returns.
For any investment, it’s always a good idea to do a health check from time to time to make sure that your money is still working for you as much as possible. So this is a great free tool to do just that for you.
Click here to get your free analysis of your 401(k) to make sure that you’re on the right track to retirement.
How do I choose how the money in my 401(k) is invested?
You’ll probably be given a list of options by your employer when your 401(k) is opened, which are provided to them by an investment broker.
Sometimes the options on the list aren’t great, but you do have to choose one of them to take advantage of the benefits outlined above.
Your choice from the list will depend on your risk appetite – that is, how much risk you’re willing to take on.
(Not sure how to determine your risk appetite – or even what a “risk appetite” is? Then take a look at this article: THE SIMPLEST INVESTMENT PORTFOLIO YOU WILL EVER NEED)
The options will more than likely involve one of the following (source).
Stocks are generally the highest risk but have historically had the best returns over time. In addition to looking at the returns over previous years, make sure you look closely at the management fee as this can really eat into your returns. You want high historical returns and low management fees.
(See this article for exactly how a one percent difference in management fees can cost you tens of thousands of dollars over time.)
These have a target date – for example, 2040 – which is your theoretical “target date” for retirement. The fund will then be managed for you until that date with no need for you to make any adjustments.
These are the most hands-off option for your 401(k), so involve no management from you, although this means that fees can be higher. They also don’t allow you to be more or less aggressive, depending on how much risk you’re willing to take on, which is something for you to weigh up.
These are a mix of stocks and bonds with a set ratio of each.
(What’s a bond, you ask? This article can help!)
These are a great way to get the returns of stocks while limiting some of your risk by having bonds. That said, if you’re young, you don’t want your bonds to take up too much of your investments as while this limits your risk, it also limits your returns.
If you’re not sure what sort of split you should have between stocks and bonds, check out this article for some guidance: HOW TO BUILD YOUR VERY OWN EXPERT INVESTMENT PORTFOLIO.
Bonds/Managed income funds
These are meant to keep your money safe rather than grow it. If you’re older than 50 with some money saved up, these are a good way to make sure that you don’t lose your money while allowing it to grow a little bit.
However, if you’re younger, you should probably stay away from this option as you’d really be sacrificing returns on your investments as you’ll never be able to afford to retire.
Money market funds
This is almost the same as just keeping your money in a low-interest checking account. It’s considered as an alternative to cash which you should only choose if you’ve saved up enough for retirement and you want to keep your money safe with practically zero growth.
Suffice to say, I wouldn’t recommend this if you’re trying to grow your money for retirement.
Having a 401(k) that’s working as hard for you as it can is one of the most important things that you can do to set yourself up for retirement.
After all, the benefits are clear: you pay less tax, you can get free money from your employer and it’s set up to grow over time so that you’re making your money work for you.
It may be tempting to avoid contributing to a 401(k) because you’re not sure exactly how to set it up or you may want to hold on to the money yourself.
But it’s not at all as difficult as it may seem. In addition, you’ll almost certainly earn more money for retirement from putting some of your income into a 401(k) rather than taking it now, even if you intend to put it into a savings account.
(And especially if you don’t quite trust yourself not to spend it.)
If you don’t have a 401(k) yet, check with your employer on how to get started. And if you do have one, make sure that it’s earning as much for you as possible by checking on some of the potential issues outlined in this article.
What steps are you taking to get ready for retirement?