A 401(k) plan is one of the best resources available for saving and investing for retirement. It's a win-win: You get to lower your taxable income in the present while setting yourself up financially for the future. There's no right or wrong way to go about your 401(k), but there are tips and best practices that can help you get the most out of your plan or avoid doing things that will slow down your progress.
Here are three things that could kill your 401(k).
1. Not taking advantage of an employer match
One of the better parts of many 401(k) plans is the employer match since it's essentially "free" money. At the very least, the minimum amount you should be contributing to your 401(k) is whatever percentage your employer will match. If they offer a dollar-for-dollar match up to 3% of your salary, contribute at least that 3%. There are few guarantees in the stock market, and an employer match offers an instant return on your contributions.
So if you make $100,000 and your employer matches up to 5%, not only is that an extra $5,000 in the present, but that's also an additional $5,000 in your holdings that has time to grow and compound. Even with a modest 8% average annual return, $5,000 could turn into over $23,000 after 20 years.
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2. Relying strictly on target-date funds
Target-date funds are designed for people who want to take a "set it and forget it" approach to their 401(k), and that's not necessarily a bad thing -- it's just oftentimes an expensive one. As you get closer to retirement, target-date funds automatically reallocate the investments they hold to become more conservative, shifting away from stocks toward more bonds and cash. Because they manage the reallocation for investors, target-date funds tend to be more expensive than other index fund options.
But a target-date fund is often a "fund of funds," so instead of paying the high fees that usually come with them, you can invest in the cheaper fund options yourself. As long as your 401(k) elections include a variety of large-cap, mid-cap, small-cap, and international funds, you're in great shape. Going this route can easily save you tens of thousands of dollars in fees over the life of your 401(k) plan.
3. Being too conservative far away from retirement
Everyone has a different appetite for risk. However, regardless of your risk tolerance, it's important to remember that in your younger years, when you're decades away from retirement, you should be focused on growing your money, which usually means taking on more risk. You're unlikely to generate the savings many people will need in retirement by strictly investing in low-risk, low-return assets like bonds.
As you get close to retirement, your focus can shift to preserving your portfolio. Small-cap and mid-cap stocks are generally riskier and more prone to volatility than large-cap stocks, but they also present a chance for higher returns thanks to their greater growth potential. They don't have to make up the bulk of your 401(k) portfolio by any means, but you definitely want some exposure to small-cap and mid-cap stocks.
That doesn't mean taking on excessive risk, especially if the resulting volatility prevents you from sticking to your long-term investing strategy. But if you're decades away from retirement, take advantage of the long time horizon and give yourself the opportunity to record higher returns.
