Saving for retirement in a 401(k) plan offers tax benefits that can be helpful when planning for the future. Some employers match the contributions you make, up to a certain amount or according to other criteria, which allows your funds to grow more. The challenge of setting up a 401(k) plan is selecting an asset allocation, which refers to how you invest your contributions. You need to decide if you want to invest in stocks, bonds or other types of investments. For example, you could have 50% of your contributions invested in stocks and 50% invested in bonds. You can usually change your asset allocation periodically.
When determining the right asset allocation for your 401(k) plan, it’s important to consider both the risks and rewards of different options. It can be helpful to understand what is available and the costs of each option. Use the following guidelines to decide how to invest your funds in a way that matches your age, lifestyle and retirement goals.
Determine your risk tolerance
The level of risk you are comfortable with can vary greatly from individual to individual. When assessing your risk tolerance, “It’s important to consider your emotions,” says Julian Schubach, vice president of wealth management at ODI Financial in Lynbrook, New York. “Think about how you would feel if your account suffered a 10% loss in a given period. Would you panic and stop contributing? Would you continue to focus on long-term growth and only bring you no reactionary change?”
If you’ve contributed to retirement accounts for years, you can reflect on your reactions to changes in the past. For newcomers, starting with less risk can help you focus on understanding how funds work. “Dip your toes into investing before you jump straight into the water,” says Schubach. “Consider a conservative fund first and if you feel you want to take more risk, adjust your allocation.” Some 401(k) plans include resources, such as quizzes, to help you gauge your risk appetite.
Select your investments
Once you understand your risk tolerance, you can sort out the types of investments. The 401(k) provider will list your plan options. “Most of the time they will be sorted by key asset classes such as domestic stocks, large caps, small caps, alternatives and bonds,” says Alex Caswell, wealth planner at RHS Financial in San Francisco.
You’ll want to keep the big picture in mind when choosing your investments. For example, if your goal is to have a certain amount saved when you retire, you can start with that number and work back to see how much you want to set aside now and where to put the funds. Also consider if you have savings in different accounts in addition to the 401(k) plan.
“Investments in a 401(k) should be reviewed to ensure they are appropriate before they are allowed into the plan, so many investments in the plan come from quality fund families and can help a anyone achieve their retirement savings goals,” says Kevin Chancellor, CEO of Black Lab Financial in Melbourne, Florida. “However, it can also present a double-edged sword in that the selection of individual funds is generally limited compared to other savings vehicles such as IRAs.” A financial advisor can help you choose the investments that are right for you.
Compare investment costs
A 401(k) plan has fees associated with maintaining the account and your investments. Some of these costs are fixed, while others are variable depending on the investment options you have chosen. “Fixed fees can include platform costs and record keeping costs, which remain constant regardless of the fund you invest your money in,” says Schubach. “A variable cost in a 401(k) will be in the different funds you can select for your contributions.”
To sort out the costs involved, look at the fund expense ratio in your 401(k) plan. Your employer can provide you with information about the cost of holding each fund in the 401(k) plan and what fees to expect. Some companies also offer information sessions to help you set up your 401(k) or access a financial advisor. “Do your best to pick the fund with the lowest fees as long as it performs in line with the benchmark,” Schubach says.
Simplify with a target date fund
A target date fund will allocate your assets for you based on your estimated year of retirement. If your 401(k) plan includes this option, it can make the process easier. “The fund will be allocated more to stocks the further you get from the date and will become more conservative and have a larger allocation to bonds as you get closer to retirement,” Caswell said.
If you’re looking for simplicity, this option may be fine, but it will depend on your overall goals. “Target date funds can be a good investment choice for new investors who don’t have access to an advisor and don’t know how to build a diversified portfolio,” says Schubach. “For more sophisticated investors or those working with a financial advisor, building a more personalized portfolio using individual funds based on your goals might be more beneficial.”