As a personal-finance writer, I find the most common question friends and family ask me, by far, is, "Will you help me set up my 401(k)?" And while I'm always happy to oblige, setting up your 401(k) doesn't need to be a daunting task. With a little bit of knowledge, you can construct a 401(k) that can help you achieve your retirement goals.
1. Decide how much you want to contribute
The first decision to make is whether to contribute (hint: the answer is "yes") and if so, how much. If your employer offers some type of matching contribution, at a bare minimum you should contribute enough to take full advantage. Even if it seems like a stretch financially, not taking advantage of your employer's match is literally refusing free money.
On the other hand, if your employer doesn't offer a matching program, you should still contribute, at a minimum, 5% or so of your salary. Whether you have a matching contribution or not, I always recommend a contribution rate of at least 10% to make sure you have enough income after retirement. If you can't get there right away, that's OK. Start with a smaller contribution percentage and try raising it by 1% per year, or every time you get a raise.
2. Know the different types of 401(k) funds
Most 401(k) plans have four different categories of investment funds to choose from. Here's a basic description of each one.
- Equity (stock) funds. These are mutual funds that invest in stocks, and you'll generally see these labeled in terms of the size of companies they invest in (small, medium, or large) and the type of companies (growth, value, or a blend). You'll also see some international stock funds, which can give you exposure to foreign markets. For the time being, it's sufficient to know that in general, smaller stocks tend to have more growth potential while larger stocks are less volatile. Similarly, value stocks tend to be more stable, while growth stocks tend to have more growth potential, as the name implies. Of course, there is more to it than that, but knowing these basic guidelines can get you started.
- Bond funds. You may also see these listed as "fixed income" or "income" funds. Basically, bonds are intended to produce income. These are less risky than stocks but also have far less return potential.
- Money market funds. Essentially, investing in a money market fund is like sticking your money in a savings account, and we all know how low interest rates are these days. The advantage of these funds is that you won't lose money, but your money won't grow much, either.
- Target-retirement funds. These are the funds you'll see listed with a certain year in the title. For example, a fund titled "Target Retirement 2040" is intended for workers who intend to retire within a few years of 2040. Designed to be an all-in-one retirement investment, these funds invest in both stock funds and bond funds, and automatically shift your assets into lower-risk investments as you approach retirement.
3. Decide on your asset allocation
Simply put, "asset allocation" means how you divide your money among stocks, bonds, and other investment types.
As a simple rule, you should invest most of your 401(k) assets in stock funds while you're young, and gradually shift some money into bonds (and maybe cash) as you get older. I like to use the "110 rule," which says that if you subtract your age from 110, it will tell you the ideal amount of assets you should have in stocks, with the rest in bonds.
For example, I'm 35, so that means that I should have about 75% of my retirement assets in stocks and 25% in bonds. Of course, you can adjust these numbers to match your risk preferences -- I keep most of my 401(k) assets in stocks because I want to maximize my growth potential.
I generally advise against holding any money market or cash-based funds in your 401(k). Bonds aren't much riskier, and will produce significantly better income. The only exception is if you're already retired and have an extremely low risk tolerance, it's OK to keep a small percentage of your 401(k) in cash.
4. Give the investment funds some quick analysis
Don't be alarmed that I used the word "analysis" -- we're going to keep this simple. I just want you to take a quick look at a couple of things in your 401(k)'s information packet or website. Specifically, for each fund, take a look at:
- Expense ratios. This tells you the fees each investment fund charges. And, all things being equal, lower is generally better. For example, my 401(k) from my previous employer has two different large-cap growth stock funds sporting expense ratios of 0.38% and 0.60% with similar performance history.
- Past performance. In general, your 401(k) fund literature will list past returns of each fund, listed over different periods of time. The long-term performance ("10-year" or "since inception") is most important to retirement investors.
Using the combination of expense ratios and fund performance, you can choose the best values for you, keeping in mind that certain types of stock funds are generally riskier than others. Determine which stock and bond funds are the best options for you, and using the asset allocation you came up with in the previous step, spread your money among a handful of the best options. In my own 401(k), I have 90% of my money allocated to three different stock funds in equal proportions (large-cap value, mid-cap growth, and international) and 10% into one bond fund.
5. Do your homework
It's true that one of the best aspects of a 401(k) is that it's a relatively low-maintenance type of investing. You select your funds, and investment managers do the research and stock-picking for you. However, it's important to do a little maintenance every now and then.
Specifically, as you get a little older, it's important to gradually shift your allocation from stocks to bonds, using the asset-allocation rules discussed earlier. The last thing you want is for your portfolio to be 90% stocks at age 65, when a market crash hits and wipes out 30% of your savings. So every few years it's a good idea to make a small shift in your allocation.
To sum it up, setting up your 401(k) doesn't need to be tough, as long as you understand the basic concepts discussed here. The most important thing is to contribute as much as you can, as early as you can. If you do this, and invest your money appropriately, you'll be on your way to a financially secure retirement.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.