Your 401(k) Is Not an Investment Plan. Here’s What
Establishing and contributing to a 401(k) is a great foundation for financial security in retirement, but the account itself is not an investment plan.
For a quick analogy, think about your last trip to the grocery store. Your shopping cart is 401(k); it is the bowl where you will put all your ingredients for dinner. Those ingredients (your investment funds) and your recipe (your investment strategy) are what get you the results you desire.
What a 401(k) offers
Retirement accounts like 401(k)s are valuable tools designed with features to make building your nest egg easier than investing in a high-yield savings account or investing in a taxable brokerage account. These accounts offer:
- Pre-tax contributions: Because 401(k)s are funded with pre-tax dollars, contributions can help lower your tax liability during your working years by reducing your taxable income.
- Tax-deferred growth: Your investment income also grows tax-deferred. Reinvesting every dollar you earn helps you reach your goal much faster, and if you pay taxes on retirement withdrawals, you may be in a lower tax bracket.
- Employer matching: Most employers (more than 4 in 5, according to research from the Plan Sponsor Council of America) match employee contributions up to a certain limit. This is actually free money.
- Maximum contribution limit: Finally, while individual retirement accounts (IRAs) have similar tax-deferral provisions, 401(k)s have much higher contribution limits.
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What the 401(k) lacks
Retirement plans often have automatic enrollment options for contributions, which may not be the best fit for your needs. Just like you have to settle on a shopping list and a recipe for a delicious meal, you need to be able to choose your finances and asset allocation to reach your financial goals.
The meat and potatoes of your investment plan, so to speak, are the funds in which your contributions will be invested. Each fund within a 401(k) has a prospectus, which you can think of as a user’s guide. Inside the prospectus, you will find several important pieces of information.
The investment objective will give you an understanding of the components of that fund and the goal it aims to achieve. A fund may seek aggressive growth, wealth preservation or a combination of both. This includes information about what securities are in the fund.
An expense ratio will tell you how much of your income goes to administrative and management costs. Thinly managed funds such as index funds have very low fees, some as low as a tenth of a percentage point.
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The investment plan is defined
Think of your asset allocation as a recipe to follow: Typical 401(k) offerings are US stock funds, international stock funds and bond funds. Each of these categories offers unique growth potential, and having a diversified portfolio helps you balance growth and risk.
Your allocation is the percentage of your contributions that will go into stock funds versus bond funds. Here’s what this might look like in practice: If you have a 70/30 allocation, that means 70% of your contributions go into stock funds and 30% into bond funds. You can also split the stock portion, allocating 50% to domestic stock funds and 20% to international stock funds.
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Basically, this means that once you set up your account, you will see a list of funds that you can invest in. Many people will be better served by index funds, which track the performance of an index such as the S&P 500.
Index funds offer broad diversification to facilitate growth while reducing your exposure to market risks. Since they’re easy to handle, they’re also low-cost, meaning you get to keep (and reinvest) more of the dollars you earn.
