401(k) plans are one of the most popular retirement plans in the U.S., having blown past pensions as the primary employer-sponsored plan. And unlike pensions, 401(k)s require participants to choose where to invest their savings. While the options in most 401(k)s are significantly limited compared to your typical brokerage account, they can still have a big impact on your finances. You’ll want to choose a fund or funds that reflect your risk tolerance and time to retirement.
401(k) Investment Options: Target-Date Funds
You’ll almost certainly see target-date funds as an option – perhaps a default option – in your 401(k). A target-date fund is a mutual fund which chooses investments based on the year the investor plans to retire. For instance, if it’s the year 2020, you’re 25 years old, and you plan to retire around 65, your target retirement date would be 2060. The fund you choose might have a name like “Schwab Target 2060 Fund” or “Fidelity Freedom 2060 Fund.”
The funds are premised on a fundamental precept of retirement planning: That the aggressiveness of your portfolio should be dictated by how long you have until retirement. Early in your career, when you’re trying to grow your nest egg aggressively, you should invest primarily in stocks. As you approach retirement – and thus would have less time to recover in the event of a market downturn – you transition to more conservative investments.
Thus, the asset allocation of the fund is based on how long you are from your target retirement age. And the allocation changes automatically as you get closer to that date, so you don’t have to rebalance your portfolio yourself.
Target-date funds are available in essentially every 401(k) plan, and many investors opt to invest their contributions in them rather than building their own portfolio of funds. With a target-date fund, you can diversify your investments and choose an asset allocation that aligns with your time horizon. But you don’t have to do any of the work.
There’s also no rule that says you have to pick a fund near your target retirement age. If you’re 20 years from retirement but have a high risk tolerance, you might pick a fund with a longer time horizon. The result will be a more aggressive and risky portfolio.
401(k) Investment Options: The DIY Approach
Target-date funds aren’t for everyone, and some prefer to adopt more of a hands-on approach. You typically can’t invest in specific stocks or bonds in your 401(k) account. Instead, you often can choose from a list of mutual funds and exchange-traded funds (ETFs). Some of these will be actively managed, while others may be index funds.
So what kinds of funds and investments can you expect to see?
You can bet that almost every plan will have large-cap stock funds. These are funds made up entirely of large-cap stocks, of stocks with a market capitalization of over $10 million. Large-cap stocks make up the vast majority of the U.S. equity market, so your 401(k) will almost certainly have multiple funds to choose from that invest in them. Notable large-cap funds include the Fidelity Large-Cap Stock Fund (FLCSX) and the Vanguard Mega Cap Value ETF (MGV).
Another type of mutual fund you’ll likely find in your 401(k)’s catalog of option is a bond fund. A bond fund is a mutual fund that invests solely in bonds. Within this category exists several categories like corporate bond funds, government bond funds, short-term bond funds, intermediate-term bond funds and long-term bond funds. Bond funds are popular because, as a general rule, they provide the safety of investing in bonds, but they’re much easier to buy and sell than individual bonds. Still, bonds aren’t risk-free: Longer term bonds can be hurt by rising interest rates, and so-called “junk” bonds are at risk of default.
You can also be confident that your plan will include an international stock fund. This is a mutual fund made up of stocks of companies outside the U.S. Some, like the Vanguard Total International Stock Index (VGTSX), combine international stocks from both developed and emerging markets. Others will invest in only one or the other, like the Fidelity Total Emerging Markets Fund (FTEMX). Many financial advisors will recommend a good mix of domestic and international stocks.
If you like, you can invest some of your contributions in an index fund, some in a bond fund and some in an international stock fund. In general, you should invest more aggressively early in your career; this might mean being more heavily weighted toward stocks, and could even mean investing in small-cap funds – that is, the stocks of smaller companies, which are riskier but offer more opportunity for growth.
Regardless, you should gradually lower your risk as you get older and your 401(k) grows. This process is what the target-date fund does for you. If you’re taking a DIY approach, you should make sure to periodically rebalance your 401(k) portfolio.
Rebalancing is the process of buying or selling shares of funds in order to return to your target asset allocation. If one of your funds grew from 45% to 50% of your portfolio in a year and another dropped from 30% to 25%, you would sell enough shares of that fund to move back to 45%, then buy shares of the fund that dropped. This allows you to buy low and sell high and keeps your portfolio balanced.
A 401(k) plan is an employer-sponsored defined contribution plan in which you divert portions of each paycheck into an account that grows until you retire and begin withdrawing funds. 401(k) plans are offered exclusively through employers. Because of this, you’ll need to have a job with a company that sponsors a plan if you want access. It’s called a defined contribution plan because you contribute a set amount of money to the fund; you choose how much to contribute, up to a certain limit ($19,000 annually for 2019). This is in contrast to a defined benefit plan like a pension, where it’s the benefit in retirement that is defined.
One of a 401(k)’s best features is that any contribution you make is tax-deferred. What that means is that the money you divert from your salary goes straight to your 401(k) without being subject to any income tax. You will, however, have to pay income taxes on the money when you take it out in retirement.
There are two main benefits to tax-deferred retirement plans. First, you may be in a lower tax bracket in retirement when you’ll have to pay these income taxes (since you’re no longer collecting a salary). Second, you can deduct your contributions from your taxable income, thereby decreasing your tax liability.
Some employers will match your 401(k) contributions up to a certain percentage of your salary. If your employer matches any contributions, you should make every effort to at least contribute that amount. If you don’t, you’re losing out on a free boost to your retirement savings.
Tips for Saving for Retirement
- In any retirement conversation, it’s important to be mindful of the retirement tax laws in the state you live in. Taking your state’s laws into account can make a significant difference as you plan for retirement.
- If you already have some money to spare, you could save even more by finding a financial advisor. A financial advisor can take a comprehensive look at your finances and determine where you can save more. With SmartAsset’s financial advisor matching tool, you answer a series of simple questions about your financial goals and situation. Then the tool will pair you with up to three qualified financial advisors in your area.
Photo credit: ©iStock.com/SolisImages, ©iStock.com/William_Potter, ©iStock.com/AndreyPopov