Being a highly successful investor requires a thorough understanding of the stock market and investment products, an eye for opportunity, and a healthy dose of luck. But if you're new to investing, you may not feel confident in your ability to gamble with your hard-earned cash. Fortunately, there's a simple way to get started investing that won't backfire -- contributing to your 401(k).
Many employers offer these tax-advantaged savings accounts to their employees to help them save for retirement. Some employers will even match a percentage of employee-contributed funds. You can choose to grow your money in a number of mutual funds or other investments preselected by your employer, and harness their gains to grow your nest egg.
It sounds simplistic, but it makes an enormous difference in your savings, especially if you start early in your career. Here's a look at how 401(k)s work and tips on making the most of yours to ensure you have a comfortable retirement.
Benefits of 401(k)s
The reason 401(k)s are so popular is that they can help you grow your savings more quickly than you'd be able to in a savings account. Plus, you get to deduct your contributions off of your taxable income for this year and your employer may also match some of your contributions, easing some of the burden of saving for retirement on your own. I discuss each of these three major benefits in more depth below.
1. Compound growth
The best reason to contribute to a 401(k) is compound growth. This is not to be confused with compound interest. You might see compound interest with a savings account, for example, where you contribute a certain amount and then each year, that accrues interest. Over time, your interest also begins to earn interest if you're not withdrawing any money from the account. With compound growth, your savings will vary depending on the performance of your investments. If you make a $10,000 investment that grows by 5% this year, you'll have $10,500 by the end of the year. If it grows by 7% the next year, you'll earn 7% on the $10,500 balance, rather than on your initial $10,000 investment, bringing your total to $11,235.
Though individual stocks, stock funds, and the market overall may rise or fall in any given year, over time, the general direction has historically trended upward. Thanks to that and to dividend reinvestment -- that is, reinvesting any dividends you receive into additional shares of the underlying investment product -- your nest egg won't just grow, but will tend to grow at an exponential rate as your previous gains are invested and produce gains of their own.
Consider a single $10,000 investment in an index fund made when you are 25 years old. After a year, assuming an average 8% rate of return -- not an unreasonable figure based on the market's past performance -- it will have grown to $10,831. But after five years, it will be worth $14,908, and after 10 years, it would be $22,226. By the time you're ready to retire at 65, that will have grown into $244,000.
2. Free money through matching
In addition, many employers match their employees' 401(k) contributions up to a certain percentage of their salaries. This is an easy way for you to get free money to put toward your retirement.
But you may not get a dollar-for-dollar match. Some employers do a fractional match, for example paying $0.50 for every dollar contributed up to a set ceiling. So if your company matches $0.50 on the dollar up to 6% of your salary and you contribute 6% to your 401(k), you'll be getting the equivalent of a 3% pay raise, routed directly into your retirement account.
Regardless of what match your employer offers, your best strategy is to contribute enough to get the full match. Never turn down the easiest money you can get!
There are the tax breaks that come with traditional 401(k)s. The money contributed to a 401(k) is taken out of your paycheck pre-tax, and the IRS does not count it toward your taxable income in the year it's earned. You won't have to pay anything in taxes on those funds until you withdraw them in retirement. Depending on how much you make this year, this tax deferral could knock you into a lower marginal income tax bracket, saving you money in taxes in the near-term.
It's worth noting that if you have a Roth 401(k), you won't get that tax break. Funds contributed to these accounts are taxed in the year when you earn them -- but withdrawals from the accounts in retirement are tax free.
Make the most of your 401(k)
Contribute as much as you can to your 401(k) each year, as determined by the Internal Revenue Service (IRS). You'll be allowed to put up to $19,000 in 2019, and adults 50 and older can contribute up to $25,000. This amount is just for your contributions, and doesn't include any employer-match funds.
Once you've decided how much you want to contribute each pay period and set up the contribution, the money will automatically come out of each paycheck, so you don't have to think about it. But if you need to, you can change your contribution amount at any time. If you can't contribute as much as you'd like to right away, work on gradually increasing the percentage of your paycheck that you contribute to your retirement account over time. For example, you may only be able to contribute 5% this year, but then aim to do 6% next year and 7% the year after, if you can swing it.
Don't neglect your 401(k) once it's been set up. Check in on it periodically to see how it's doing, and rebalance your portfolio as needed. You may also want to change your investment strategy a little if some of your investments are continually losing money.
In general, you'll also want to adopt a somewhat more conservative strategy as you get closer to retirement, so that you don't risk seeing the value of your nest egg shrink too radically at a time when you're about to begin withdrawing from it. For example, you may want to sell off high-risk stock investments that are prone to large fluctuations in value and invest your money in something that's less prone to ups and downs, like stable value funds. If you'd like to make changes to your 401(k), reach out to your plan administrator or your HR department for advice on how to do this.
What if my employer doesn't offer a 401(k)?
If your employer doesn't offer a 401(k), you can still invest fairly painlessly for your retirement -- and take advantage of the power of compound growth -- by opening an IRA. Admittedly, IRA contribution limits are lower than 401(k) limits: The maximum you can add to an IRA this year is $6,000, or $7,000 if you're 50 or older. But there are far more investment products to choose from for an IRA, and their administrative fees are usually lower than 401(k)s, which may help a bit when it comes to making up for the lower contribution limits.
Investing can seem daunting, but if you have a retirement account, you're already doing it. The trick is to make the most of it by contributing as much as you can, taking full advantage of employer matching, and making adjustments to your portfolio as needed. It shouldn't require much effort on your part, and it will make a big difference to your financial security in retirement.