401(k) Investments: Should You Invest in a 401(k)?

Daniel Penzing
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We take a look at the benefits of investing in employer-sponsored plan.

So far, we’ve been talking about retirement programs that are meant to supplement your employer-sponsored plan that’s commonly known as a 401(k). For most people, the 401(k) is the cornerstone of all retirement programs. In this lesson, we’ll talk about whether you should invest in a 401(k).

Some 401(k) plans have higher fees than others. If you can choose among different levels of fees on 401(k) plans, the lower-fee one will usually outperform the higher-fee one.

So if there is a choice, you should invest your maximum in a 401(k) plan with lower fees. The fees will add up over time, so the savings will add up over time, too.

Since the 401(k) plan is meant for your retirement, you should definitely think of investing the maximum. The US Department of Labor and the IRS even require that you contribute the maximum. However, if you’re young and broke, you might not be in a position to do so.

But the benefit of the maximum 401(k) contribution is that it compels you to regularly save for your retirement. This is one of the best benefits of investing in a 401(k).

What is 401(k)?

A 401(k) plan is a retirement savings plan sponsored by an employer. Employees are eligible to participate in the plan if they meet eligibility requirements. Employers typically match a portion of employee contributions to 401(k) accounts. Employants may set limits on the percentage of income employees contribute through salary reduction.

A 401(k) generally consists of three components: employee contributions, employer contributions, and earnings on account investments.

Employer contributions are mandatory for 401(k) plans established after June 25, 1987. Employers must contribute either a percentage of each eligible employee’s salary or a percentage of each employee’s annual profit-sharing contribution.

Employee contributions are mandatory unless an employer waives it. Most employers match employee contributions up to a predetermined amount. For example, an employee may be required to contribute 5 percent of his or her pay. An employer may agree to match employee contributions of up to 5 percent.

The third component of a 401(k) is earnings, which are credited daily, weekly, monthly, or annually. Earnings remain in the account until any of the money in the account is withdrawn.

In addition to salary reductions, employers may choose to set up automatic contributions from profit sharing, and employees may choose to set up automatic contributions from wages or salary.

How Do You Invest in a 401(k)?

Start Investing in Your 401(k) As Early As Possible

This is one of the best financial tips anyone can ever get: start early! Invest as soon as you can, because the more time you give your investments to grow, the more opportunity you have to accumulate wealth. This is even more true with your 401(k) investments because your employer is helping you to save for retirement.

Typically, you have to wait until you are at least 50, or else you will be paying a 10% penalty for early withdrawals. However, many 401(k) plans allow for a special loan option to help you get out of a financial bind.

401(k) loans generally allow for the amount borrowed to be paid back in equal installments over the course of a few months. This is also a great way to test the waters with investing a percentage of your paycheck – if you can pay back the loan before longer than a year, you might as well let it ride. However, if paying the loan back seems like a problem, then you might have found your first sign of incompatibility with investing.

This might go against common financial advice, but it could work out quite well for you. If you are facing a financial emergency, take a loan from your 401(k) and pay it back as quickly as possible. Then, you can repurpose the money you were using for retirement into something else for more long-term gain.

Take Advantage of 401(k) Investment Tax Benefits

If you’re an employee, chances are that your employer offers a 401(k) program. For some jobs, it’s the only way you can save for your retirement. If you’re offered such a program, your first step is to check if you’re getting the full tax benefits available to you.

Know the Different Types of Funds Offered in 401(k)s

Just like in IRAs and regular taxable accounts, the main advantage of 401(k)s is that all contributions are made before taxes. All withdrawals, including earnings and any dividends, are also made after taxes.

With many 401(k)s, there are several investment options to choose from including index funds, target-date retirement funds and actively managed funds.

Index Funds

The simplest is an index fund. These are mutual funds that mirror the index of the stock market. For example, the S&P 500 tracks the 500 largest companies in the United States by market capitalization. It consists of the total stock market value as a percentage of the total value of all the companies in the U.S.

These funds require the least amount of work, they earn the most money for 401(k) investors and are reasonable to set up. They have the lowest expense ratio and have no management costs.

Target-Date Funds

Target-date funds are more complicated, but are still easy to understand overall. They invest in index funds, but shift their investment to safer allocations the further away the retirement date is. Their logic is that the closer you are to retirement, the more conservative your investments should be.

They have slightly higher fees and expense ratios than index funds, but not as much as actively managed funds.

Assess Your 401(k) Investment Risk Tolerance

The most important first step for any retirement income plan, whether it’s a traditional or Roth IRA, a 403(b) or a 401(k), is to assess your individual risk tolerance. The financial industry is no stranger to jargon, and there’s a special one for retirement finance. It’s called “Personal Finance” jargon, and it’s full of buzzwords such as “risk tolerance” and “timing the market.”

So what’s that all about?

Many people think that the decision about how heavily invested in stocks they should be is a matter of how much risk they can tolerate. In the business world, risk is the chance of loss. In financial markets, it’s the expectation of loss.

Diversify Your 401(k)

By law, 401(k) plans have to hold a variety of investment options for participants. If you are lucky, your plan may offer a few dozen or even a few hundred options to choose from.

Even though the choices might be overwhelming at first, you should not feel compelled to choose any particular investment option. Just because a good friend or co-worker recommends a particular fund does not mean that they have earned the right to choose your retirement investment portfolio. Instead, you should take the time to thoroughly educate yourself by taking a comprehensive class on investing or by reading books such as Investing For Dummies.

You should also make it a point to develop a healthy interest in the financial markets. Financial markets are constantly changing, and just about any fund that is offered today will likely be unrecognizable and out-of-date a few years down the road. So if you develop an interest in the economy and the various asset classes that are available, you will be able to monitor the markets more closely and make adjustments to your portfolio as necessary.

Avoid Funds With High Fees

Fees are the price of admission and is something you should keep in mind when investing.

There are two types of fees:

Expense Ratio

An expense ratio is an annual fee that is charged by the management company for investment management, governance, recordkeeping and administrative services.

Management Fees

Management fees, on the other hand, are trading costs – such as commissions or transaction costs – charged by a fund sponsor or advisor, and add up over time.

It is also worth pointing out that management fees are not the same thing as trading fees. Trading fees are the cost of buying and selling securities within a mutual fund.

Let’s take the SPDR S&P 500 ETF as an example. The fund charges a very low expense ratio of 0.10% per year. However, this low expense ratio does not include trading fees incurred for each transaction. ETF providers are not required to disclose the trading fees, which can range from 0.45% to 3.00%. Not including trading fees, the expense ratio for this particular ETF can end up being as much as 2.5%.

So the bottom line is, if you can avoid funds with high fees, you should.

How Much Should I Invest?

The first thing you need to figure out is how much you can invest. Depending on the company 401k plan, you may have a specific investing limit each year. But for the sake of this post, we will assume that you don’t have a monthly limit and are able to deposit as much as you can afford.

If you want to grow your investments to balance out inflation, your contributions need to keep up with average and inflation-adjusted salary increases. If you haven’t received an annual raise recently, check out this guide to get an idea of how much salary increase you should get.

Secondly, you will want to invest enough money so that you have sufficient funds to retire comfortably. There’s no hard and fast rule that this amount should be, but many financial experts recommend saving about 10% of your salary each year.

In addition, if you are saving for a house, healthcare costs, children’s education, or your other financial goals, you may want to add some funds for those as well.

Finally, you will want to save enough to make sure you don’t live off of your investment interest when you are older. You may have been taught that it’s a good idea to invest in a money market and live off of the interest, but the truth is that this can be risky.

Low-Income Saver Benefits

If you are a low-income individual, you are eligible for a number of tax benefits that are designed to help you set aside money for your financial future. One such benefit is a 401(k) plan that is designed for low-income earners.

A 401(k) plan is a tax-advantaged plan offered by private employers. It allows employees to set aside money before taxes. The money can be withdrawn later on, once the employee has left the company, without being taxed. While a 401(k) plan is available to most employees, the definition of a low-income earner tends to vary depending on the article or source that you read. But in general, a low-income employee is defined as someone who falls under two federal poverty guidelines.

Are Low-Income 401(k)s Right for You?

A low-income 401(k) is one of the investment options that are available to low-income earners. However, it is not right for everyone.

When you sign up for this type of plan, you must first investigate whether it is the right investment choice for you. Here is what you need to know before you decide on whether or not to use the Low-Income Saver Benefit.

Take Your 401(k) With You

Employee stock ownership plans (ESOPs) and cash-balance plans are similar, but you are usually limited to working for the employer that sponsors the plan. In contrast, a 401(k) plan will allow you to use the money in other investment options (for example, IRAs or Keoghs), as long as they are within the confines of the IRS. When you leave your employer, you can take your 401(k) with you, provided that it’s part of a qualified retirement plan.

Because it is important to make this distinction in how you invest your money, it is important to be sure you are getting the best plan to fit your retirement needs. Many employers have a 401(k) plan closed to new participants, though this may change as your employer sees the virtues of year-round recruitment. Whatever you do, remember that you should never be afraid to seek financial advice when it comes to your money and your future.

Best 401(k) Management Practices

Some of the best considerations that you can make when planning your financial future involve stable investments. The 401(k) investment plan is offered as part of the larger IRA investment plan (see IRA versus 401(k)). However, the 401(k) is more commonly associated with workplace retirement plans.

The 401(k) is just one of the many workplace investment options that people can choose. It’s also just one of the many alternatives to the 401(k). Thus, before making a decision, you should consider the advantages and disadvantages of both.

First, let’s look at the advantages of the 401(k). Employers often offer their employees 401(k) plans to provide a steady stream of income in retirement. For the employee, the 401(k) can be a convenient way to save money. The 401(k) program offers the employee the opportunity to save money with pre-tax dollars; this means that federal and state taxes are removed from your earnings before they’re accepted into your 401(k) account.

Take Advantage of Your 401(k) and Start Saving Early for Retirement

The 401(k) is a retirement savings plan that allows you to make pre-tax contributions to an investment account. As an employer-matching plan, employees are awarded a fixed percentage of their salary to be contributed towards their 401(k) by the company. You can elect to invest your 401(k) contributions into stocks, bonds, money market funds, or a combination of these investment types. A 401(k) plan is offered as a retirement planning benefit and is an accounting entry that reduces your taxable income for the year. The benefits of a 401(k) include:

  • Tax Deferred Growth Of Account
  • Low-Cost Investments Available
  • Company Profit Sharing
  • Take Advantage of Your 401(k) and Start Saving Early for Retirement