5 Tips to Get the Most Out of Your 401(k)

If you’re like most US employees you probably have a company sponsored 401(k) plan — at least if you work for a more established business. Unfortunately, learning how to best manage a 401(k) is rarely ever taught, so if you feel a bit overwhelmed or confused don’t fret. Using 401(k)s to build wealth is actually pretty easy. Start with these 5 tips:

1. Start Now! Don’t Delay.

This is a point we hammer time and time again. When it comes to building wealth, time is your #1 friend. The earlier you begin saving and investing, the exponentially better off you will be in the end. Sadly, only 41% of eligible workers contribute to their 401(k)s. This neglect, short-term impatience, or whatever it is that’s stopping them from contributing is assuredly crippling their future net worth and retirement potential.

Too many young adults believe that saving money starting later will be totally fine. While, sure, most people can still scrape by when delaying saving, that mentality will inevitably lead to major regrets. Change your future for the better by putting your 401(k) to work right now!

2. Take Full Advantage of Employer Matching

Is there really such a thing as free money? Well, uh, yeah! Most businesses incentivize their employees to save for retirement by offering 401(k) matches. The scope of any match depends on the respective business, but these matches are essentially free money. If your employer matches up to 4% of your salary, then you better be plugging at least 4% into your 401(k)! If lower, definitely match. If the percentage is higher, finding a way to save those extra percentages is totally worth it. That’s an instant 100% gain right there — letting that opportunity slip by is maniacal!

One general rule of thumb is to save at least 10–15% of your earnings for retirement. There’s a decent chance that your 401(k) will be the majority of that, so even if your match is low, save anyway. Between your 401(k) and your IRA, you’ll be set.

3. Choose Between a Roth or Traditional 401(k)

Traditional 401(k)s are standard practice, but increasingly more employers are beginning to offer Roth 401(k)s, too. The difference boils down to taxes.

  • Using a Traditional account allows you to delay taxation. Instead of paying income taxes upfront when the money is received, you pay upon withdrawal — in retirement. Plus no capital gains taxes.
  • Using a Roth account means you will pay income tax you upfront but then never pay taxes again on that money (including capital gains).

As another rule of thumb, if you think you’ll be in a higher tax bracket in the future a Roth 401(k) is the way to go (and most people who save and invest fit this mold). If the reverse is likely, then a traditional account may be ideal. The same can generally be said for IRAs as well. Of course, tax policies change over time and your personal situation may be different. Consult a tax advisor to receive personal advice.

4. Don’t Be Overly Conservative

A shocking 43% of 18–25 year olds think that cash is the best investment vehicle for money not needed for at least 10 years. That is so far from the truth.

As you can imagine, countless individuals act too conservatively in their 401(k)s. If you’re young, you can — and probably should — invest more aggressively. That likely means leaning far more towards stocks (equities) than cash and bonds. What most people fail to realize is that when time is on your side, more volatile investments aren’t actually riskier. Here’s proof (from Stocks for the Long Run):

As you can see, over time stocks are safer… plus yield higher returns than both bonds and treasury bills! Volatility is almost always short-term noise, despite how fantastic or depressing you may feel at any given time.

Your 401(k) plan is likely filled with several different fund options. While I don’t know your specifics, choose your allocations with this in mind. When time is on your side, you don’t need to be afraid of volatility or act nearly as conservatively. Although there’s nothing wrong with keeping some money in cash and bonds (for diversification’s sake), your future self will thank you significantly more if that money is placed into equities. Investing in the entire S&P 500 index or a total world fund is a good first option.

5. Watch Out for High Fees!

High fund fees are an issue that’s existed since the dawn of funds. It’s important to remember that the funds you invest in are managed by companies that want their cut of the action. Fees can seriously limit one’s gains if not careful, so don’t overlook this step. Most people give up more than they even realize by failing to look at fees. Fortunately, these days most big fund groups are cutting their fees in the fight to stay relevant and retain market share.

One reason to prefer index funds over actively managed mutual funds is because they tend to hold lower fees (not to mention they also outperform most mutual funds). Hopefully index funds are an option in your plan. If not, check out the equity funds with the lowest fees. You might not know exactly what to opt for, but when in doubt invest in the options with the lowest fees.

It’s Not That Hard

Managing your 401(k) isn’t as hard as it may seem. As long as you start early, contribute enough to gain full matching, invest according to your long-term time horizon, and avoid high fees you’re in excellent condition. Plus, once your allocation settings are in place, you can leave it be and let time do all the heavy lifting. When you check back in a few years, you’ll be astonished to see just how much you gained.