Whether you're just opening your first retirement savings account or you've had one for decades, you need to make sure your 401(k) (or IRA) is set up to bring in as much money as possible. The higher your investment returns are, the less money you'll need to save out of your paycheck in order to have enough money once you retire.
Let's go through the steps of priming your retirement savings for impressive long-term gains.
Save until it hurts
Sometimes it takes money to make money, and that rule applies to your 401(k) account. Make as much room in your budget for retirement savings as possible, and aim to contribute at least 10% of your income. Ideally, you'll save 15% or more.
Setting your 401(k) contribution level is easy: Just talk to your HR representative or log on to the plan website to set your automatic contributions to the percentage you desire, and you're done. With an IRA, things get a bit more complicated. You'll have to figure out the dollar amount you can contribute each month (or whichever interval you choose) and set up an automatic transfer from your checking account. For example, if your monthly wages come to $4,000, then a 10% contribution would be $400 per month, and a 15% contribution would be $600 per month.
Pick the right allocation
Stocks and bonds are hands-down the best retirement savings investments. The easy way to allocate your money between stocks and bonds is to subtract your age from 110 and put that percentage of your money in stocks, with the remainder in bonds. For example, a 30-year-old would have 80% of their money in stocks and the remaining 20% in bonds.
If you consider yourself to be pretty comfortable with risk, then you could invest more aggressively -- perhaps subtract your age from 120 and invest the resulting percentage in stocks. If the thought of losing a big chunk of your money (at least temporarily) to a stock market dip might keep you up at night, then you might go a more conservative route and subtract your age from 100. In any case, the benefit of this simple formula is that it encourages you to invest primarily in stocks, but it also gradually lowers your exposure to stocks (and the associated risk) as you age.
As a rule of thumb, the more money you have in stocks, the higher your average returns will be but the more roller-coaster-like ups and downs you'll experience in your portfolio balances.
Pick the right investments
If you want to maximize your returns, you need to minimize fees and taxes. You've already done a good job of dodging excessive taxes simply by putting your investments in a 401(k) or IRA, which shields your savings from taxes on capital gains and dividends. Keeping your fees as low as possible can be a bit trickier, though.
Passively managed mutual funds and ETFs have far lower average expense ratios and other fees than actively managed funds and ETFs. That's largely because actively managed funds have to pay someone -- and usually pay them a lot -- to figure out which investments to buy or sell. On top of that, actively managed funds tend to trade more frequently, so they generate higher transaction costs, which are then passed on to the individual investor.
One of the best options for a core retirement savings stock investment is a low-cost S&P 500 index fund. The S&P 500 index includes a broad collection of big, mature companies, providing excellent diversification and relatively low risk. Best of all, index funds tend to have minuscule expense ratios.
On the bond side, a passively managed bond fund or ETF is a great option. For retirement savings investments, stick with funds that purchase intermediate or long-term bonds and are composed of Treasury securities and a few investment-quality corporate bonds.
Once you have your 401(k) humming along, you can leave it alone -- for a while. At least once a year, have a look at how the investments are performing. If a fund or ETF is producing disappointing returns while comparable funds have thrived, consider trading it in for a different one. Funds that have hiked up their fees are also a good choice for swapping out. Even if all your investments are performing well, you'll likely need to do a little buying and selling in order to maintain the right percentages of stocks and bonds.
For example, let's say you have $10,000 in your 401(k) at the beginning of the year, and you've put $8,000 of it in stocks and the other $2,000 in bonds. Stocks typically produce higher returns than bonds, so it's likely that your stock position will grow faster and take up an increasing percentage of your portfolio. So when you go back to your account a year later, you might find that you now have $9,000 worth of stocks and $2,100 worth of bonds, meaning your stock/bond ratio is now 81/19 instead of the original 80/20. You'll need to sell some stocks and buy more bonds to get your asset allocation back where you want it.
What returns can you expect?
Over the long term, large-cap stocks (such as you'd find in the S&P 500 index) have returned close to 10% per year on average, while bonds hover around 4% to 5% per year on average. In the short term, however, returns can vary enormously. That's why it's important not to panic if a market crash causes the value of your retirement savings to drop suddenly. When you have years or decades to go before you retire, you don't need to worry about short-term swings in the market. Your stocks and bonds will have plenty of time to recover and then some.