The 401k plan is the best retirement plan available to the average American. If the plan is offered by your employer, be sure to take advantage of it.
And do everything along the way to maximize your contributions and the performance of the plan.
How to Maximize Your 401k Investment
There are several strategies you can use to invest and maximize your contributions.
Get on your 401k as soon as possible
It often makes sense to postpone your retirement plan until a little later in life, when your finances are more solid. For example, you can wait to pay off the student loan debt. However, since this can take many years, waiting for the retirement plan will result in a severe penalty.
For example, let’s say you are adding 10% of your $ 50,000 income to your 401,000 plan by the age of 25. With an average annual return on investment of 7% (a mix of stocks and bonds), you will save approximately $ 1.035 million by age 65.
However, if you wait until you’re 35 and contribute 10% of your $ 100,000 income, again assuming a 7% annual return, you’ll only have a little over 980,000 by the time you turn 65 U.S. dollar.
We didn’t even take into account that once you start contributing at 25, based on a higher annual income, you’ll gradually increase your contributions. Assuming a 3% annual salary increase, your plan will grow to over $ 1.55 million by age 65, with the contribution rate remaining at 10%.
Timing is everything with a 401k.
Maximize your employer contributions
A common question on a 401k plan is how much should i contribute. The best answer to this question is as much as you can! For example, a contribution of 10% is better than 5% and 15% is better than 10%.
However, you should make at least the lowest percentage contribution that results in the maximum employer contribution.
For example, if your employer is 50% of your contribution, up to 10% of you (which makes a 5% match), you should contribute at least 10%.
Between your 10% contribution and your employer’s 5% contribution, 15% of your income goes into your plan each year.
Using the example above, if you contribute 10% of your income from age 25, a 50% employer match by age 65 results in approximately $ 1,552,500. That is how important the employer’s contribution is.
One restriction to be aware of in the employer match is the transfer of contributions. Vesting refers to the point where the funds that contributed to your 401k plan are entirely yours.
Your own contributions to the plan will automatically vest when they are made as the funds come from your own income. However, employer contributions generally delay the exercisability.
For example, the embargo period can last up to six years until you own 100% of the employer match.
Depending on how the vesting schedule for your plan is set, the employer contributions may be vested on a percentage basis each year. For example, 20% of the game can be vested after the second year you’re on the plan, then 40% after the third year, and so on. Usually you are fully vested after five or six years.
Consequences of leaving before you are fully vested
If you leave your employer before you are fully vested, you may only be able to keep a percentage of the game. And if you go early, you may not be able to keep any of the game.
Employers use extended vesting schedules to keep employees with the company for several years. It is particularly effective when the employer makes a very generous matching contribution.
The vesting schedule is necessarily an important factor if you are considering leaving your employer before you are fully vested.
Gradually increase your 401,000 posts
So far, we’ve given examples of how you can add a fixed percentage of your salary to your 401k plan. As your salary is likely to increase over the years, the dollar amount of your contributions will increase accordingly. If you contribute 10% of a $ 50,000 salary in your first year of employment, you will save $ 5,000 on the plan. However, if you make $ 100,000 10 years later and still contribute 10%, your annual contribution will increase to $ 10,000.
This of course results in an even higher plan balance when you are 65 years old.
An even more effective way to make your plan grow faster is by increasing your contribution percentage.
This strategy isn’t as dramatic as it sounds. Perhaps you will contribute 10% for the first year to receive the maximum employer contribution of 5%. Let’s say your salary increases an average of 3% per year. With each increase you allocate an additional 1% to your 401k contribution.
After your first increase, your contribution percentage increases to 11%. After the second increase, it rises to 12%. When you have five raises, this increases to 15%.
If you continue to use this strategy for another five years, you will eventually bring 20% of your salary into the plan. And since the increases are gradual and tied to your raise, you won’t even notice.
You can continue to increase your percentage contributions until you reach the maximum contribution limits for the plan. For 2020 that’s $ 19,500 per year or $ 26,000 if you’re 50 years or older.
Your ultimate goal should be to get as close as possible to the maximum contribution allowed by the IRS. This, and your employer’s contribution to it, can greatly improve your plan.
Avoid borrowing loans for your 401,000 or early withdrawing funds
Both borrowing against your 401k and withdrawing funds early can affect the value of the plan. Here’s how:
According to IRS regulations, you can borrow up to 50% of the vested balance on your 401 (k) plan, up to a maximum of $ 50,000. But that is both good news and bad news.
On the good side, you can borrow against your 401 (k) plan without having to qualify based on income or credit rating. The interest rate is usually lower than what you would pay for a bank loan and certainly lower than the credit card rates. And since the monthly repayments come from your regular 401 (k) premiums, it doesn’t weigh on your budget.
However, there are several reasons you should avoid borrowing for your 401 (k):
- Although the IRS allows 401 (k) loans, not all employers offer them.
- The main purpose of a 401 (k) plan is retirement. If you borrow against the plan, you will at least somewhat detract from those efforts.
- The outstanding loan balance will not be available for investment, which will decrease the overall return on your plan.
- Loan repayments on a 401 (k) loan are not tax deductible.
There is another important caveat when it comes to 401,000 loans. If you are outstanding on a loan and terminate your employment for any reason, you will have to repay the loan. Under the latest tax law, you have until the due date of the tax return for the year of termination, including renewals, to repay the loan.
If you fail to do so, the outstanding loan proceeds will be treated as an early distribution subject to normal income tax plus a 10% penalty if you are under 59½ years old.
Once again, the entire purpose of a 401k plan is to ensure your retirement. If borrowing against the plan can reduce its future value, early withdrawals are even more destructive.
For many people, retirement savings are their primary savings. It makes sense because you have to take care of the last few decades of your life. However, if you don’t have a ton of cash on retirement plans, you might be tempted to withdraw funds from your 401k plan to meet your financial needs.
In most cases, your current employer will not allow you to withdraw funds from the plan. However, you may be able to withdraw funds from an old 401k plan or from a plan that has been transferred to an IRA account.
When you withdraw money from a retirement plan, you have up to 60 days to return the money. Otherwise they are considered an early distribution. Similar to 401,000 unpaid loan proceeds, they are subject to normal income tax plus a 10% penalty if you are under 59½ years old.
Just as bad, however, is that early withdrawals from a 401k or other retirement plan can cause them not to find their way back. That is, they become permanent withdrawals from plans to finance your retirement.
If you need additional funding in the short term, you should exhaust all other options before moving on to making early withdrawals from your retirement plan.
Create the right portfolio mix for your age, goals, time horizon and risk tolerance
Aside from how much you add to your 401k plan, the next most important factor is how effectively you are investing the money. To get the most out of your retirement investment money, you need to have the right mix of stocks and bonds in your portfolio.
Probably the most common strategy for determining the mix of stocks and bonds in a portfolio today is 120 minus your age. The difference is the percentage of your portfolio that should be invested in stocks, with the balance allocated to bonds.
This is just a rule of thumb and you can adjust it to suit your personal preferences. But it works something like this:
Let’s say you are 25 years old. You determine your stock portfolio by subtracting your age of 25 from 120. That makes 95 years. This means that 95% of your portfolio should be invested in stocks and 5% in bonds. If you’re 40, 80% should be invested in stocks (120 minus 40) and 20% in bonds.
Because the formula is based on your age, your stock allocation will gradually decrease as you age.
The specific investments that you should make in your retirement plan will largely be determined by the options available in your plan. In general, however, your investments should be held in index-based exchange-traded funds (ETFs). These are low-cost funds that are linked to certain market indices. This allows you to invest in a market without having to select individual stocks.
Here’s the best way to manage your 401k
Probably the most effective overall strategy for managing a 401k plan is consistency.
A 401k plan, like any retirement plan, is a long-term investment. This requires a long-term perspective and ongoing commitment.
Make sure to fund your plan every year you are entitled to. It is especially important that you fund your plan regularly for the first few years. The time value of money states that the longer money is invested, the higher the return on the plan.
Again, you should plan to gradually increase your percentage contributions as your income grows.
Diversify your age portfolio allocation
Appropriate diversification is also important. If you’ve invested 80%, 90% or more in stocks, you need to spread them across several sectors.
While you should have a large allocation in US stocks, especially the S&P 500 index, you should also have an allocation in international stocks. This can be split evenly between developing and emerging countries.
You may not be sure how to build a solid portfolio allocation. If so, complete a risk tolerance questionnaire to aid in the process. You can find these at all major brokers including Vanguard and Charles Schwab.
Realignment of your portfolio
Realigning your portfolio is another often neglected management strategy. Unless your 401k plan offers some kind of asset management, you’ll need to do it yourself.
Rebalancing is all about aligning your portfolio allocations with your investment goals. For example, if you’ve determined that 80% of your portfolio should be invested in stocks and 20% in bonds, this breakdown may change over time. If your stock portfolio has grown significantly and your bonds haven’t, you might have 90% in stocks and 10% in bonds.
You need to make adjustments. You can do this by reducing your stock allocation to 80% and increasing your bond percentage to 20%.
You should plan to reorient at least annually or anytime a single market sector has seen significant growth.
Are you maximizing your 401k investment?
If properly managed – and for the best long-term effect – a 401k plan should be established for the autopilot.
You set your payroll contributions, make them consistent, determine your portfolio allocation and regularly rebalance them.
Along the way, you should also have a strategy to gradually increase your plan contributions. You should also avoid taking out loans or early distributions from the plan.
Set it up and manage it properly, and it will be the perfect passive way to develop long-term wealth!