Elm3’s Guide to Investing in a 401(k)
While earlier generations may have relied on pension plans to fund their retirement, most workplaces have moved towards defined contribution rather than defined benefit plans. Many pension plans were defined benefit plans, which promised a certain benefit at retirement. These plans required employers to assume the risk that the invested funds would underperform the guaranteed benefit. In order to reduce employer risk, most employers moved towards defined contribution plans, such as 401(k)s. Employers agree to contribute a certain amount each year, or match a certain amount of employee contributions, but no longer promise a guaranteed benefit at retirement. Instead, employees bear the risk of their investments underperforming. As a result, it can be helpful to take the following steps in order to best manage investment risk within your 401(k) account.
- Whenever possible, maximize your 401(k) contributions. In 2023, individuals under the age of 50 can contribute up t0 $22,500 to a 401(k), and individuals 50 or older can contribute up to $30,000 to a 401(k). These contribution limits do not include employer contributions. Maximizing contributions, especially earlier in your career, both can increase your retirement nest egg and reduce your current tax burden.
- Monitor any Roth 401(k) contributions. Having a Roth 401(k) can be beneficial as it allows individuals to diversify the taxation of their retirement income. Retirees pay income tax on traditional 401(k) distributions while qualified Roth 401(k) distributions are tax-free. However, Roth 401(k) contributions are taxed at your current income tax bracket. If you are in a high income tax bracket, it may not be in your best interest to make significant contributions to a Roth 401(k). Your income tax bracket may be much lower in retirement, and if such is the case, it could be much more beneficial to pay income tax on traditional 401(k) distributions rather than Roth 401(k) contributions. Moreover, Roth 401(k) contributions reduce the amount you can contribute to a traditional 401(k). Traditional and Roth 401(k) contributions are added together when determining if you have met or exceeded the contribution limit for the year.
- Diversify your investments according to your risk profile. Younger, growth-oriented investors might focus more on large-cap stocks, with a smaller or minimal allocation towards bonds. Older, income-oriented investors might increase their bond allocation and reduce their large-cap stock allocation. It can be helpful to also consider funds that expose you to small-cap, mid-cap, and international stocks. A well-diversified portfolio is better situated to weather a stock market storm than a poorly-diversified portfolio.
- Consider the performance and expense ratios of your investment choices. Many 401(k)s offer actively-managed, target date funds. While these funds can reduce the burden on the investor to select the appropriate mix of investments for their account, these funds can feature high expense ratios. Compare the expense ratios of your different fund options. In general, index funds will offer lower expense ratios than actively-managed funds, and keep in mind that expense ratios eat into your account’s growth. You should also look at both short-term and long-term performance. Funds may be performing well during the past month, but how have they been performing during the past year, three years, or five years? Understanding a fund’s long-term performance can help you determine the stability of its returns.
- Review dividend or income yields. Bond funds or income-oriented funds may not boast the strongest performance, but what are these funds’ income yields? A fund that offers a strong dividend yield could add value and stability to your portfolio through guaranteed income.
Reach out to our financial planning team if you have questions regarding workplace 401(k)s.
