A 401k or 403b is a fantastic place to begin building a nest egg, but making the most of the plan can be confusing.
Deciding When Uncle Sam Gets His Cut
You’re going to pay tax at some point on money in the plan. It’s up to you to decide whether you pay it now or when you begin withdrawing in retirement. With traditional 401k/403b plans you won’t pay taxes on the income until you begin withdrawing in retirement. On the flip side, many companies now include a Roth option, meaning your contributions are taxed today just as if the money had been deposited to your bank account, but withdrawals at retirement are tax free.
For working professionals in their 20’s and 30’s, we love the Roth option. You’ll be building a savings that will be tax free when you need it at retirement.
Maximize your Match
The number one rule for getting the most out of your plan is to make sure you’re contributing at least enough to get your employer’s match. We’ve seen companies match as high as 8% of their employees' contributions. This is your company offering you free money just for deciding to save your own money. Unless you have high interest debt that needs to be tackled (a topic for another day), make sure you know your company’s matching provisions and contribute at least this much.
Diversify and Watch the Expenses
Here are the two best pieces of advice we can offer when it comes to actually selecting the investments inside your plan:
- Make sure you select investment across the entire globe (US Stocks, International Stocks, Emerging Markets and Bonds)
- Look for funds with the lowest expense ratios. These will typically be called “Index” funds. In many cases, expense ratios on these funds can be as little as 1/10th the cost of actively traded funds.
Allocating your percentages depends heavily on the funds offered by your company, your own tolerance for risk and how aggressive you need to be to reach your goals. If you’re in your 20’s or 30’s and have decades until retirement, you’ll likely want to be a little more aggressive with your money and consider putting 70-80% of your money in stock funds and 20-30% in short term bonds.
Avoid Employer Stock
If you work at a publicly traded company, it’s likely that there is an option to invest directly in your company’s stock within your 401k. Some executives are required to hold a percentage of their salary in company stock. If this applies to you, we suggest holding that amount and no more. If you don’t have this requirement, we suggest little to no company stock. Holding heavy concentrations of your employer’s stock leaves you undiversifed. You’re betting way too big on the same company that is paying your salary, bonus and future increases in pay. If the company were to hit hard times, not only could your job be at risk, but you could at the same time lose a substantial portion of your retirement savings. For this reason, we suggest minimizing company stock within the plan and instead holding a globally diversified basket of stocks.
It’s likely that your 401k has provisions that allow you to borrow money from the plan; we strongly suggest avoiding this if at all possible. Most plans will allow you to borrow 50% of your balance up to $50,000 as long as you pay it back within 5 years. This can be extended if the funds are being borrowed for a down payment on your home. However, we believe a 401k loan should only be used in cases of extreme need--you’re going to lose your home, a loved one needs money for a life and death medical situation, etc. You’re playing with fire when you borrow from your 401k not only because you risk penalty of not being able to pay it back in time, but because you rob yourself of the 8th wonder of the world--compound interest. You’re money isn’t working for you when you’ve borrowed it.
Consider this example: a 30 year old who hopes to retire at age 60 borrows $50,000 from her 401k. She plans to pay it back in 3 years. Her money now has 3 less years to compound. If she is earning an average of 7% per year inside the 401k, this 3 year loan means she has $69,919.37 LESS at age 60! Don’t rob yourself of compound interest.
To avoid getting into dire situations where you’d need to borrow from a 401k, make sure you have an ample emergency fund!