Your 401(k) Isn’t an Investment Plan. Here’s What Is
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Establishing and contributing to a 401(k) is a great foundation for financial security in retirement, but the account itself isn’t an investment plan.
For a quick analogy, think of your last trip to the grocery story. Your shopping cart is your 401(k); it’s the vessel where you’ll put all of your ingredients for dinner. Those ingredients (your investment funds) plus your recipe (your investing strategy) are what get you your desired end result.
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What the 401(k) provides
Retirement accounts like 401(k)s are valuable tools designed with features to make building your nest egg easier versus just socking money into a high-yield savings account or investing in a taxable brokerage account. These accounts offer:
- Pre-tax contributions: Because 401(k)s are funded with pre-tax dollars, contributions can help decrease your tax bill during your working years by lowering your taxable income.
- Tax-deferred growth: Your investment earnings also grow tax-deferred. Reinvesting every dollar you earn helps you reach your goal more quickly, and when you do pay taxes on withdrawals in retirement, you may be in a lower tax bracket.
- Employer match: The vast majority of employers (more than 4 in 5, according to a survey from the Plan Sponsor Council of America) match employee contributions up to a certain limit. This is essentially free money.
- High contribution limit: Finally, while individual retirement accounts (IRAs) have similar tax-deferral provisions, 401(k)s have much higher contribution limits.
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What the 401(k) lacks
Retirement plans generally have default enrollment choices for contributions, which might not be the best fit for your needs. Just like you have to settle on a shopping list and a recipe to cook a delicious meal, you need to be able to choose your funds and asset allocation to reach your financial goal.
The meat and potatoes of your investment plan, so to speak, is the funds into which your contributions will be invested. Each fund within a 401(k) has a prospectus, which you can think of as a user’s guide. Within the prospectus, you’ll find a few key pieces of information.
The investment objective will give you insight into the components of that fund and the goal it aims to fulfill. A fund may seek aggressive growth, wealth preservation or a combination of the two. This includes details about what securities are in the fund.
The expense ratio will tell you how much of your earnings go towards administrative and management fees. Passively managed funds such as index funds have the lowest fees, some lower than a tenth of a percentage point.
The investment plan defined
Think of your asset allocation as the recipe you’ll follow: Typical 401(k) offerings are U.S. stock funds, international stock funds and bond funds. Each of these categories offers unique growth potential, and having a diverse portfolio helps you balance growth and risk.
Your allocation is the percentage of your contributions that will go into stock funds versus bond funds. Here’s what this might look like in practice: If you have a 70/30 allocation, that means 70% of your contributions are going into stock funds and 30% into bond funds. You might further divide the stock portion, allocating 50% to domestic stock funds and 20% to international stock funds.
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In practice, this means that once you set up your account, you’ll see a list of funds you can invest in. Many people will be best served by index funds, which track the performance of an index like the S&P 500.
Index funds offer broad diversification to facilitate growth while mitigating your exposure to market risks. Since they’re passively managed, they also tend to have the lowest fees, which means you get to keep (and reinvest) more of the dollars you earn.