Your 401(k) can be your ticket to a nice retirement, assuming you play your cards right. Your workplace-sponsored retirement plan streamlines long-term wealth creation, by way of automatic, tax-deductible contributions that get invested according to your preferences.
If you did nothing but accept your 401(k)'s default contribution rate and investment choices, you would see your account balance grow over time. But there are easy ways to expedite that growth and give you the best shot at reaching your retirement savings goals. Here are five of them.
1. Get your full employer match
If you have access to employer match, use it to the fullest extent. It's free money, and that's hard to come by. Look through your 401(k) documentation to find out how much you need to contribute to get your full employer match. It's usually a percentage of your salary, around 3% or 4%. Set up your contribution rate to be at least that amount.
2. Know the vesting schedule
Employers don't usually give you full ownership of those matching contributions right away. Normally, your ownership is phased in over time, according to a vesting schedule. For example, you might start off being 20% vested and then earn an additional 20% each year. In that case, you wouldn't fully own those matching contributions until year five of your tenure.
Should you decide to switch jobs, any unvested contributions are forfeited -- which would be a costly setback to your savings plan. The takeaway? Consider any lost matching contributions when evaluating a new job offer. If the new salary is much higher, you could increase your contributions to make up for your lost employer match. But if it's a lateral move, sticking it out with the old employer might be the better choice.
3. Choose funds with low expenses
You don't have to be a financial whiz to make good 401(k) investment choices. Start by comparing the expense ratios of your fund options. A fund's expenses directly reduce shareholder returns, which is why the expense ratio is considered a good predictor of future fund performance. The lower the expense ratio, the better.
The expense ratio isn't your sole decision-making factor, however. You should also care about the type of fund. If you have 10 years or more before your targeted retirement, you could invest solely in a low-cost S&P 500 index fund. That would give you a low-maintenance, diversified portfolio of large companies that mimics the growth of the overall stock market. Legendary investor Warren Buffett has long been a proponent of S&P 500 index funds, as has billionaire investor Mark Cuban.
4. Diversify the easy way
Shares of an S&P 500 index fund offer some level of diversification. But you might want more, particularly if retirement is near or if you have low risk tolerance. You can easily accomplish that in your 401(k) by investing in multiple funds.
A simple and conservative approach would be to divvy up your contributions, with 60% going to an S&P 500 index fund and 40% going to a U.S. bond fund. The bond fund won't grow much in value, but it will produce income and add stability to your portfolio.
You could also carve away a piece of your S&P 500 index fund allocation to put in an international equities fund. That would give you exposure to other economies and currencies. The international equities will be more volatile than domestic ones, so you'd want to keep that percentage lower, say 10% of your overall portfolio. That would leave 50% for your S&P 500 fund and 40% for your bond fund.
5. Rebalance to manage risk
If you do choose two or three funds, you'll have to rebalance your portfolio once or twice a year. Rebalancing is the process of making trades to return your portfolio to its targeted composition.
Say you set your contributions to be invested this way: 50% in U.S. equities, 10% in international equities, and 40% in U.S. bonds. Each of these funds will grow at different rates, with riskier assets growing faster. If you don't rebalance, you end up over-weighted in risky assets and under-weighted in stable ones. In a year, for example, you might be sitting on 53% U.S. equities, 12% international equities, and 35% bonds.
Log in to your 401(k) to see if you have the option to rebalance automatically. Set that up if you can. Otherwise, you can do the job manually. Sell off your over-weighted positions and use the proceeds to buy up more of your under-weighted positions to get back to the 50/10/40 composition you want.
Do the work, and wait
If you max out your employer match and commit to sticking around until you're 100% vested, you're already off to a good start with your retirement plan. Then, make sure those contributions are invested in low-cost funds and diversified across asset types. Finally, plan on rebalancing once or twice a year to keep your risk level in check.
What's after that? Increase contributions whenever you can, and watch your nest egg take shape over the next 10 or 20 years.