A 401(k) plan can be invaluable in saving for retirement. However, achieving your retirement goals isn't just a matter of how much you save. Your 401(k) rate of return, or the amount your investments earn each year, also plays a significant role.
With your 401(k) returns, results will vary depending on several factors. Some of these, such as the stock market's performance, are out of your hands. But the decisions you make about how you invest have a big impact, as well.
What is a good 401(k) rate of return?
The average 401(k) rate of return ranges from about 6% to 8% per year for a portfolio that's 60% invested in stocks and 40% invested in bonds, according to Vanguard. A good rate of return would be anything on the higher end of that range.
If you invest a higher percentage in stocks, you'll typically earn higher average returns. Investing conservatively by allocating more to bonds reduces your risk of losing money, but it also produces lower returns. Keep in mind that short-term fluctuations are normal, and long-term results are what really matter.
There's also a surefire way to boost the returns on the money you contribute: Take full advantage of your employer's 401(k) match. If your company matches 50% of your contribution, that's a 50% automatic return on your investment.
Five factors that affect your 401(k) returns
Your 401(k) rate of return depends on several factors beyond the stock market's performance. Here are five things that affect how much your retirement account earns:
1. Consistency of contributions
The beauty of a 401(k) plan is that, thanks to payroll deductions, you're automatically dollar-cost averaging. This means you're investing a fixed amount at regular intervals. To get the best 401(k) rate of return, be consistent and don't change your contributions based on short-term stock market performance.
Dollar-Cost Averaging
2. Asset allocation
The ideal asset allocation depends on your age, target retirement date, and risk tolerance. If you have a long-term horizon and a high risk tolerance, you'll want to invest heavily in stocks. Investing more in bonds is recommended as your retirement date gets closer or if you have a low risk tolerance.
Investing primarily in stocks usually produces higher average 401(k) returns, but it also increases your risk of losing money, particularly in the short term. However, if you invest too heavily in bonds, especially at a young age, you may not achieve the returns necessary to meet your retirement goals.
3. Investment options
The average 401(k) plan offers eight to 12 investment options, according to FINRA, with mutual funds being the most common. Many are index funds, which means your returns will mirror an underlying benchmark index, such as the S&P 500, although your earnings will lag slightly due to fees. Look for a fund with a low expense ratio to minimize fees.
4. Retirement age
Another common type of mutual fund you'll find in 401(k) plans is target-date funds. You choose a target retirement date, and the fund automatically rebalances to bonds and cash equivalents, such as money market funds, as that date approaches. You get greater stability, but that translates to lower average returns the closer you get to retirement.
5. Fees
Higher fees mean that less of your money is actually invested, resulting in lower returns. Even seemingly small fees can have a big impact. Suppose you invested $5,000 annually in your 401(k) and earned 7% average annual returns. Paying a 0.5% fee vs. a 0.25% fee would reduce your returns by over $20,000 after 30 years.
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How to calculate a 401(k) annual return
Here's how to calculate your 401(k) return for a one-year period:
- Take the ending balance and subtract contributions made over the past year.
- Divide by the starting balance from one year ago.
- Subtract 1 and multiply the result by 100. That will tell you the percentage of the total return.
If you've used a period other than a year, there's more math involved. Take the number you got from dividing the adjusted ending balance by the starting balance, and then use an exponential calculation as follows:
- For a two-year period, you'll need to take the square root. On a calculator, use the power key to raise the number to the 1/2 power. For a three-year period, you'd raise it to the 1/3 power, and so on.
- Then, take the final answer, subtract 1, and multiply the result by 100 to get the average annual return.
The longer the period you're measuring and the more contributions you've made, the less accurate this simple calculation will be. A more appropriate calculation is the time-weighted return, which measures actual investment portfolio performance regardless of deposits or withdrawals.
For most situations, both methods will yield results that are reasonably close to each other and accurately reflect your performance. Regardless of which measurement you choose, ensure that you regularly review your 401(k) returns to verify that your investment decisions align with your goals.
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