Whether you're starting a new job or staying where you work right now, it always makes sense to look at employee benefits you've earned. That includes reviewing your 401(k) plan if your employer offers one.
If you want to get the most out of your 401(k) account, you obviously need to contribute money of your own. But you also need to pay attention to what you're investing in. Too many people fail to do this, and for many, it leads to a costly mistake.
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Letting your account run on autopilot could be a bad move
Your 401(k) lets you choose between a variety of funds your employer has pre-selected. You're free to change your investments at any time. However, sometimes when people agree to participate in their 401(k), they defer some of their income without indicating what they'd like to invest in.
Typically if this happens, the 401(k) plan invests your money in a default investment option. This might be a balanced fund that invests in both stocks and bonds or it could be a target-date fund. Target-date funds are designed to automatically change their asset allocation over time, becoming more conservative as they approach the target year listed in their name. This year is supposed to correspond with the year that you retire.
The default investment may not be the right choice for you for a few reasons. First, it might be too risky or too conservative for you. Both are dangerous. If you take on too much risk, you open yourself up to larger losses. That's problematic, especially near retirement age. Being too conservative can slow the growth of your investments, forcing you to put in more of your own money than you would have needed to if you'd adopted a slightly more aggressive investment strategy.
Some investments can also have high expense ratios. These are annual fees the mutual fund charges shareholders. It's usually written as a percentage of your assets. So a 1% expense ratio means you pay $1 for every $100 you have invested in the fund each year. You typically want to stay below this if you can, so you can hold on to more of your money.
Choosing the right investments for your 401(k)
It's possible your 401(k)'s default investment is a good fit for you. But there's no way to know this until you investigate it and compare it to the other available options.
You likely have an online account where you can view your retirement plan details and make adjustments as needed. If not, talk to your HR department or 401(k) plan administrator to learn about your investment options and how to change them.
Start by looking at the fees you're paying. Your prospectus should have this information. Keep in mind that fees may be listed as a percentage of your assets, like the expense ratios discussed above. If you find you're paying more than 1% of your assets per year, consider switching to a more affordable fund if there are any available.
Next, look at how your investments compare to your risk tolerance. Generally, younger workers have higher risk tolerances since they have plenty of time to recover from losses. Risk tolerance declines as you age and focus more on protecting what you have. However, risk tolerance also varies by individual. Some people are comfortable taking risks for potentially greater gains while others prefer to play it safe.
You'll have to decide the appropriate risk tolerance for you. If you're not sure what to choose, a target-date fund for the year you plan to retire in could be a good fit as long as its fees are reasonable. Your 401(k) plan may also offer educational resources to help you determine which investment options are best for you.
Keep in mind that you'll likely have to complete this process more than once. Your risk tolerance will change over time and it's possible that the investments available in your plan may change as well. Be prepared to repeat this process at least annually or whenever you experience a major change to your finances or retirement plans.
