Principles of Saving for Retirement Through the 401(k)

The dollars in your 401(k) plan may represent as much as 80% of your income at retirement. With the 401(k), the government and your employer allow you to take advantage of two very powerful financial concepts: the ability to save money on a pre-tax basis, and the tax-deferred, compounded growth of those dollars.

Benefits of a 401(k) Plan

This program enables you to build a better nest egg due to tax-deferred growth. Saving money before it is included in your taxable income reduces your annual tax bill. In addition, the earnings can grow on a tax-deferred basis, which means you can earn money on your earnings!

Your Obligations

If your company offers a 401(k) plan, you need to be contributing as soon as you can and as much as you can. It is the first step in taking charge of your financial future. To help you increase the size of your nest egg and encourage reluctant employees to save for retirement, your employer can match 50% of your contributions equal to up to 6% of your eligible salary. Contribute now; otherwise, you're just turning down free money.

The Goal of Fund Matching

The only catch is that you must contribute some of your own money to receive the company match. If your employer matches up to 6%, you should be contributing at least 6%. The goal is to capture the entire company match and hopefully keep working there until you’re fully vested.

The following considerations can help you identify and assess your investor profile:

Knowing Yourself

Every investor is different. Knowing yourself is the first step to allocating your investments appropriately. Before determining your asset allocation strategy, you should first define your goals. Remember, 401(k) money is retirement money to achieve those goals. Each goal may represent a separate pool of money, and there are different investment options available to help fund each goal.

Calculating Your Time Horizon

Second, determine the time horizon for retirement. Is it more than 10 years away? The longer you have until you need the money, the more heavily weighted you should be in stocks. You’ll have more time to recover any losses incurred during a market downturn.

Weathering Market Downturns

This consideration concerns how psychologically comfortable you are with market downturns. Can you tolerate the inevitable ups and downs that the stock market delivers?

What Is Asset Allocation?

This is the principle of deciding how to spread your investments across various asset classes, such as stocks, bonds, and cash. There are subcategories within each asset class—small, medium, and large cap stocks. Within equities, there are growth securities, value securities, and blend securities that have characteristics of both.

Types of Asset Class

Each asset class has different risk and return tendencies. For example, small-capitalization stocks tend to be more volatile than large-capitalization stocks. However, they also tend to have higher returns in the long run, which you would expect to receive more reward for taking more risk. This is referred to as a risk premium.

Risk is defined as the measure of how much a security fluctuates in price. For example, a security with returns of 20% one year and –20% the next is riskier than a security that has returns of 5% one year and –5% the next. The amount of risk a person should accept within their portfolio depends on several factors:

  • When You Need the Money (Not Automatically Dictated by Your Retirement Age)
  • How Much Money You Have Now and Expect To Need Later
  • What Level of Risk You’re Willing To Take

Time Horizon

This is perhaps the most important factor in evaluating market risk. When you have more time, there is more risk than you can handle. For example, from 1926 until 2020 the range of compound annual returns for small-cap stocks over a one-year holding period was from a high of 140% to a low of –60%. However, if you extend the holding period to 20 years, the range is from a high of 22% to a low of 5%.

Amount of Risk

How much risk you should take also depends on your goals. If you’re not late for work, why speed? In other words, you don’t have to take a risk when you are on target to meet your goals.

Level of Risk

Be sure to take the level of risk that you’re comfortable with. If you find yourself unable to sleep at night every time your portfolio loses value, then you shouldn’t be taking such a risk.

After understanding each asset class and the factors impacting the amount of risk, you can now prepare a diversified asset allocation. Diversification combines assets to optimize return for a given level of risk. First, evaluate the risk and return tendencies of various investment options and how risk can be reduced and return can be increased when asset classes are combined in the right proportions.

Market Timing

However, be aware that no investment plan or asset allocation strategy can eliminate the risk of fluctuating prices and uncertain returns. Do not try to time the market because there are no proven strategies that market timing can consistently beat a well-allocated portfolio.

When retiring, you don’t have to move all your money into bonds and stay clear of the stock market. Just make sure that your investment holdings grow more than the rate of inflation. This way, the income from your investments will have the same purchasing power when you’re 85 as it does when you’re 65. Regardless of your age, partially invest in stocks since they can outperform inflation consistently.

Always monitor your investment portfolio. If one asset class has outperformed others significantly, then your portfolio is likely to be out of balance. Regular rebalancing can be a disciplined approach to buying low and selling high. You may also consider other tactical moves if an investment suffers from style drift, a change in management, or similar investments with lower expenses become available.

Example Scenario

If you wanted to have 70% of your money in stocks, and it has grown to represent 80% of your portfolio, you need to rebalance your portfolio.

Hearing about the market changes daily can cause anxiety. Stocks fluctuate in value naturally. 401(k) plan is a long-term investment, so there is a clear direction of the stock market over the period. Constant downward dips and swings are inevitable, which is why knowing how you’ll react to those swings is a factor in your overall asset allocation.

Investment Tips

Selling when your investments are down is the best way to lock in your losses. However, patience is a virtue in investments. Unless the investment cannot recover definitely, it is usually best to hold on for the ride and buy more assets.

Every 401(k) plan has unique characteristics. Distributed by your benefits department, your plan documents will outline different features, such as the following:

Hardship Withdrawals

This feature is allowed for most plans. Some several tax and penalty issues are associated with hardship withdrawals, so make sure you read your plan documents carefully and seek professional guidance. If you choose hardship withdrawal, you may be suspended from the plan for a specified period.

Vesting Schedule

This refers to the years of employment before the company match money becomes yours. Vesting schedules either are graded (you get a percentage of the money in successive years of employment) or cliff (you get all the money at once after no more than five years). Keep the vesting schedule in mind if you’re planning to quit.

In-Service Withdrawals

If the plan does not meet your investment needs, and it allows for in-service withdrawals, you can move some of the money into other vehicles like an Individual Retirement Account (IRA). This account gives you many options for investing your money while enhancing your diversification abilities.

Loans

Early 401(k) plans had no provision for loans. Participants often save for retirement if they could access the money before they retired. They also mistakenly believe that a 401(k) loan is better than other loans because of its lower interest rate. That may be true, but it does not take into consideration the real cost of the loan, which is the lost opportunity cost.

Example of Lost Opportunity

Money in your plan cannot grow if it is not there. If the investments in your plan are growing by 12%, that is what borrowing from the plan costs you plus growth on that growth.

Tax Consequences

When you borrow money from your plan, you need to pay the loan back with after-tax dollars. Then, when you withdraw money during retirement, you will pay taxes on those dollars again. This means borrowing from your plan is an extremely expensive option. Borrow only if you must.

Limitations to Moving Money

Many 401(k) plans allow you to buy the plan sponsor’s stock, which can be a double-edged sword. Yes, you may want to participate in the growth of the company by being a shareholder. However, it is risky to have too much of your portfolio in one stock. Creating a non-diversified portfolio means one company can control your salary, benefits, pension, and 401(k) plan.

In the case of 401(k), you can avoid several negative tax consequences. If you quit your job and want to take your 401(k) money with you, be sure to roll it over directly to an IRA or another employer’s plan. You may leave it in your former employer’s plan only if you have more than $5000 in your account. If you take a full distribution, you will pay federal and state taxes on the entire amount.

Early Withdrawal Penalties

If you are not yet 59 ½, you also will pay a 10% penalty. This will not help your retirement nest egg and reduce your lump-sum distribution to almost half its original value. Do not take a lump sum at retirement and take out only what you need. This way, the bulk of the portfolio can continue to grow tax-deferred.

Mandatory Withdrawal

If you are over 72, you must follow the required minimum distribution rules. Rolling your money from your 401(k) to an IRA may make sense for a variety of reasons, and fortunately, an IRA rollover is not a taxable event.

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