401-OK

Credit: Ambro

Many people, including me, have been handed a 401(k) election form when they first started work with a new employer. It’s another form among the masses, so you quickly check a few boxes, consider the percent you think you can afford to have taken out of your paycheck, and that is that. Then a quarter passes and you’ve made a little money. Maybe a year passes and you’ve saved up some money, but your investment return looks a lot like the trajectory of an incoming meteor. Either way, most people have a lot of questions about their 401(k) that they never take the time to ask, and your 401(k) is way too important of a retirement planning vehicle to not understand what you’re doing. A friend of mine asked me for some help a few weeks ago, and I want to tell you what I told her so you, too, can hopefully make the most of your 401(k).

First, if you can possibly afford it, put in whatever percentage is required to get the maximum employer match. If your employer doesn’t match anything, that stinks; you should still contribute what you can. If they do match, take them to the cleaners! Let’s say that you make $100,000 a year, your employer will match your contributions up to 3%, and you are putting in 2%. That means you are putting in $2,000 and your employer is putting in $2,000, but if you put in $3,000 your employer would have to put in $3,000. That’s essentially a $1,000 raise right there! After you’ve forced your employer to match you, put in as much more as you can towards retirement but know there are annual contribution limits ($17,000 for 2012 if you are under 50 years old, $22,500 if you are over 50 at any time in 2012).

Second, if your employer offers different 401(k) plan types, you are going to have to make a choice between a traditional 401(k) and a Roth 401(k). Personally, I would choose a Roth 401(k) instead of a traditional 401(k) because Roth 401(k)s are taxed when you put money in, but the earnings you accumulate are tax-free when you take money out. Traditional 401(k)s are not taxed when you put money in, but the money you put in and the earnings you accumulate are taxed when you take money out. I relate this choice to scheduling getting your wisdom teeth out. By that, I mean that the taxes have to come out sometime and it’s probably going to hurt a little, but it is up to you when to schedule the procedure. Future tax rates and future investment return rates years from now will dictate what the best plan choice would have been today, but don’t get too caught up in that; what matters is that you are saving for retirement.

Third, choose investments that match your goals, risk tolerance, and stage in life. I’m going to make this way too simple:

• I’d offer up that if you are between the ages of 20-35, you should roughly invest 80% in stocks and 20% in bonds or fixed income.
• If you are between the ages of 35-55, you can afford less volatility and risk, so you should probably invest about 70% in stocks and 30% in bonds or fixed income.
• If you are over the age of 55 or retired, you are probably more focused on preserving and maintaining your assets, so you should consider investing closer to 60% in stocks and 40% in bonds or fixed income.

I would also tell you that out of the stocks you invest in, I would roughly recommend 60% to be in mutual funds of large U.S. companies, 20% to be in mutual funds of small U.S. companies, and 20% to be in mutual funds of international companies, so you are nice and diversified. Please note that my very broad suggestions are simply suggestions and do not take into account what might be best for your personal financial situation. If you want more specific investment advice than that, I would be happy to help, but you probably need to be a client…

Finally, don’t touch it! Your 401(k) is for your retirement only, not for your new BMW. You should know, that with very few exceptions, 401(k) withdrawals made prior to age 59 ½ will face a 10% penalty. Now I don’t want you paying penalties, but I certainly don’t want you lessening your ability to retire at a reasonable age living the lifestyle you’ve grown accustomed to. Simply check your statements and leave your 401(k) alone. Pretend it is an angry yellow jacket or raging black bear if that helps.

I hope that the next time you get your 401(k) statement you will take a look, remember my suggestions from this post, and make your 401(k) a lot better than just okay.  

-Tom