If you have a 401(k) or similar retirement plan at work, the smartest thing you can do is to learn some basic concepts about retirement investing, such as proper asset allocation, how 401(k) fees work, and how much you should be contributing. With that in mind, here are some tips that can help you maximize the long-term growth power of your 401(k).
1. Take full advantage of your employer's match
If you don't contribute as much to your 401(k) as your employer is willing to match, you're literally turning down free money. For example, if you earn $50,000 per year and your employer is willing to match contributions of up to 6% of your salary, that's an extra $3,000 in compensation that's yours for the taking.
To be fair, some 401(k) plans have high fees or limited investment options, which might tempt you to reduce your contributions and simply invest elsewhere on your own. However, in virtually all cases, you're better off getting your full match and allocating your contributions as efficiently as possible.
2. Use proper asset allocation
Speaking of allocating your contributions, it's a good idea to know about how much of your 401(k) should be invested in stocks and how much should be in bonds. While there's no one-size-fits-all secret formula, a good starting point is to subtract your age from 110 to determine the percentage of your portfolio that should be in stocks, with the rest in bond or fixed-income investments.
3. Rebalance your investments regularly
Setting a proper asset allocation is only the first step in long-term 401(k) success. As time goes on, it's equally important to rebalance your investments. This can be necessary because one asset class has outperformed another (for example, if stocks did better than bonds) and now your portfolio is disproportionate. Or rebalancing could be necessary simply because you're getting older and want to shift some assets from higher-risk (stocks) investments into lower-risk ones (bonds).
4. Check for lower-fee investment options
It's a popular misconception that investing in a 401(k) is free. This is never the case, even if you're not charged any fees directly.
All of the investment options in your 401(k) are mutual funds, which charge their own management and administrative fees. Collectively known as an expense ratio, this is expressed as a percentage of the fund's assets. For example, a 1% expense ratio means that $1 out of every $100 you have invested will go to paying fees each year.
The expense ratios charged by your investment options are readily available in your plan's literature, and it's a good idea to compare the fees charged by your funds to see if there may be lower-cost options that accomplish the same investing objectives.
5. Don't get out of stocks during market crashes
During the financial crisis, I heard several times from friends and acquaintances things like "I'd better get out of stocks before they go down any more."
This is the worst thing you can do to your long-term retirement strategy. Sure, market crashes can be frightening, but if anything, that is the time to buy, not sell. Studies have shown that the average investor dramatically underperforms the market over time, and a big reason is emotional, knee-jerk reactions like that. Think of it this way -- look at all the upside you would have missed out on if you sold in 2009, or in the early 2000s after the tech bubble burst.
6. Increase your contribution rate over time
Experts generally suggest that you aim to save at least 10% of your salary in your 401(k), not including employee contributions. This may sound like a lot of your paycheck to defer, but keep in mind that you don't need to get there right away.
One of my favorite 401(k) strategies is to start with the exact amount that your employer is willing to match. Then, increase your contribution rate by 1% each year until you're putting 10% of your salary into your account, or whatever your ultimate target is. If you do it this way, you'll barely notice the difference, but it can make a massive difference in your nest egg's growth.
7. Know your company's vesting schedule
In a nutshell, when your retirement account is "vested," it means that you completely own all of the money in your account. Now, your own contributions are always fully vested, but this isn't usually the case for employer contributions. Many companies have a vesting schedule, generally over a period of a few years, where the employer contributions in your account become truly yours.
If you leave your job before your vesting is complete, any unvested employer contributions are forfeited, so this is certainly important to know before you start job-hopping every two or three years.
8. Consider some Roth 401(k) contributions
Most 401(k) contributions and all employer contributions are pre-tax assets. In other words, you don't pay taxes on the money when you first receive it. Rather, the taxes on most 401(k) assets are deferred until you withdraw the money in retirement.
The problem is that this can lead to big tax bills. Fortunately, more and more employers are offering the option to make some Roth 401(k) contributions as well. You don't get an immediate tax break for these contributions, but your withdrawals in retirement from the Roth portion of your account will be 100% tax-free. This can be a smart strategy to dramatically reduce your tax bill in retirement.
9. Leave your money in the account
As a final point, perhaps the best 401(k) tip of all is to leave your account alone until you're retired. I'm not just talking about taking early cash-out distributions from the account, which, by the way, you should never do. I'm talking about 401(k) loans as well.
401(k) loans may sound like a good idea in principle. The approval process is easy, and interest rates are low, plus you're paying yourself back with the interest. However, the problem is that a well-allocated portfolio of stock and bond investments can be expected to return around 7% per year, on average, over long time periods. So by borrowing money and paying it back at a rate of say, 4%, you're robbing yourself of some of the investment returns that can eventually turn your 401(k) into a big retirement nest egg.