Here’s how to get the most out of your company’s 401(k):
1. Set your savings rate high to max out your contribution early in the year
You can invest up to $18K per year into your 401(k) (plus $6,000 if you’re 50+). Regardless of how much you plan to contribute, you don’t have to split your contributions evenly throughout the year. If you set the savings rate high, you can invest the entire amount you plan to invest in your 401(k) early in the year, then save up for other goals for the rest of the year.
I set the portion of my salary that goes into my 401(k) between 50% and 100%, depending on how much I have in my checking account. Why do this?
401(k) contributions are taken before income tax deductions (but after social security and medicare). If you allocate 50 to 100% of your income to your 401(k), you’ll see substantially more of your income go into your investments. This allows you to keep your money in the market for a longer time. (Note: verify that you will still get 100% of your company match if you do this.)
In my case, I qualified for my employer’s 401(k) late in 2016, and was just able to max it out by the end of 2016, and then maxed it out again in early 2017. $18,000*2 = $36K. The US market is up about 11.6% this year, earning me around four thousand dollars just for investing early. I didn’t invest a penny more – I just invested earlier in the year. Not every year will be so good, but overall, you’ll see a higher return by setting a higher savings rate to get your money in the market at the start of each year.
You might find it hard to live off a lower income for part of the year, but most people spent less after the end of the holiday season, and you may have a Christmas bonus to kick off the savings.
2. Choose low-priced index funds
The list of funds available for your 401(k) can be both imposing and disappointing. If you have experience choosing your own investments, it is very likely that your preferred funds are not on the list. Chances are that most of the options are overpriced – their expense ratio is higher than what you would pay in a typical investment account.
My strategy for choosing what to invest in is simple: I look for the lowest cost index fund that matches my desired portfolio. For example, my 401(k) has a “Nationwide S&P 500 Index A Large Cap” fund with an expense ratio of .6%.The equivalent ETF from Vanguard charges only 0.04%. So my 401(k)’s index fund has higher costs, but still much lower than 1.78% for some of the mutual funds my 401(k) offers. Don’t just choose funds that happened to have the highest return this year. They probably got lucky, and if they are mutual funds, the higher expenses will eventually probably lead them to underperform index funds.
3. Build a diversified portfolio and schedule rebalancing
Here is current 401(k) portfolio:
- 40% “S&P 500 Index A”
- 40% “Small Cap Index A”
- 20% “International Index A”
I built this in 30 seconds simply by searching for the word “index” in the list and verifying that these are the funds with the lowest cost on the list. This is not a very scientific ratio, but it balances long-term performance with the risk from different market categories. Whatever your risk tolerance, I suggest choosing several low-cost index funds that are different enough to offer diversification. My 401(k) also allowed me to set up automated rebalancing every quarter to ensure that my portfolio sticks to this ratio.
4. Rollover your 401(k) into an IRA when you leave your job
Normally, you can rollover your 401(k) into an IRA when you leave your job. I was able to roll over my 403(b) (like a 401(k), but for nonprofits) last year when my existing employer switched to a new provider. If you have a chance to rollover your company 401(k) to your preferred broker (see my post on choosing one), you should absolutely do so because:
(1) The IRA account providers out there (I suggest a robo-trader — I use Personal Capital) are almost certainly better than whatever your company uses – cheaper, with more investing options, and superior customer service.
(2) You don’t want to leave a trail of isolated retirement accounts from each job over the course of your career, especially if you want to build a tax-optimized portfolio using a robo-trader that automatically allocates securities in a tax-efficient manner (for example, placing REIT's and dividend stocks in the IRA and growth stocks in your taxable account).
Note: There are three reasons why you may not want to roll over your 401(k) if you’re toward the end of your career and have been with a company for a while: (1) some states (details here) protect 401(k) investments from creditors more than IRA’s (2) 401(k) allow current employees to delay required minimum withdrawals, and (3) 401(k) allow you to take penalty-free (but not tax-free) withdrawals after age 55 under certain conditions – but not IRAs.
Republished from Liberty.me