Investing in a 401(K) plan is quintessential for an average American to enjoy a happy retirement. In fact, managing it well could mean enjoying early retirement. Here are a couple of things to keep in mind while saving and investing for a 401(K).
When it comes to saving and investing, there is no such thing as starting too early. Even if you are in your 40’s, you still have sufficient time to save up for a comfortable retirement. There is no magic age to start saving in a 401(K). In fact, when it comes to 401(K), the best time to start saving was yesterday, the second-best time is today and the worst time to start is tomorrow.
The sooner you save in your 401(K), the sooner you can benefit from the compounded interest. For instance, let us consider the savings of two savers- A and B. A starts saving about $5000 a year at the age of 25 in a 401(K) and does this for ten years and stops. So, the total savings amount to $50,000. Now, B starts doing the same but starts at the age of 35 and stops at 65 years of age. The total savings amount to $150,000. Suppose the rate of return on each 401(K) savings account is 7%, who will end up with more interest? The power of compounding interest gives Saver A a balance of $600,000 whereas Saver B has only $540,000 even though he/she saved more. So, it is better to start sooner rather than later, but better late than never!
There isn’t a 401(K) savings plan that fits everyone. Therefore, the best way to go about it is to start by saving as much as you can without hurting your other financial obligations. For instance, if you try to save too much, you may not be able to afford your rent or credit card bills. So, the ideal rate is anywhere between 10-15%. However, you must at least put aside enough to your 401k plant to maximize the matching contribution from your employer. The common match is around 50% for up to 6% of your total contribution and is known as the deferral percentage. Simply put, it means that if your contribution is less than 6% of your total pay, then you will not get a full match. If you contribute 6% and your employer matches it with 50% (that’s 3%), then your total savings translates to 9% in your 401(K). Find your sweet spot for savings. Saving too little will hurt you as much as trying to save too much.
Your risk tolerance
A common mistake that a lot of investors make in their 401(K) is to not identify their risk tolerance. There are some who risk too little, and this slows down their growth. Others tend to risk too much, and this also slows them down. There are certain common mistakes you must avoid like starting too late, saving too little, exposing yourself to too much risk and not making any moves. If you want to save up enough (and more) for your retirement, you need to be proactive about it!
When you’re building your mutual funds portfolio, ensure it is diversified enough. When you diversify your portfolio, it enables you to distribute the risk across different types of investments. Instead of placing all your eggs in one basket, spread the risk. For example, for a growth investor, it is a good idea to invest 40% of your funds in large-cap stocks, about 10% in small-cap stock, 30% in bonds, 15% in foreign stock and the rest can be kept in the form of cash.
Manage it well
Whenever you get a pay hike, you must increase your savings contribution to the 401(K) as well. For instance, if you get a promotion and therefore a salary hike of 5%, you would increase the contribution to your 401(K) by 1% if you typically save 20% of your income. You will be able to enjoy your raise and save more for retirement too. Always keep the prevalent market trends in mind while investing. For instance, there has been an increase in the investment in index funds for 401(K) while there has been a steady shift away from actively managed funds in certain categories of assets. The mutual funds’ fees in 401(K) plans have decreased in the last decade or so, and the practice of revenue sharing is also declining. Mutual funds are still the most popular form of investment in 401(K) accounts, but the popularity of Roth accounts is steadily increasing. If everyone seems to be doing something, it is certainly a good idea to try and understand what they are doing and what kind of impact this will have!
Keep these simple things in mind when you are fleshing out a 401(K)-investment plan.