Have you experienced the following scenario?
You start a new job – excited about the work you get to do and the great benefits the company offers. On your first day, you are handed a stack of benefit paperwork and told to look over it, sign it, and bring it back tomorrow.
Somewhere in that stack is the explanation of benefits for your retirement plan. You must choose the amount that you want to contribute, the funds you want to invest in, and maybe whether or not you want to use the Roth provision.
You don’t know what to choose, so you say that you’ll contribute the amount that your practice will match and you pick a couple of funds to invest in based on what you can remember from your high school economics class.
For most young professionals, their 401k plan is their primary (if not only) investment vehicle. Your company or practice may have a different company-sponsored plan, like a 403(b), 401(a), or 457(b) plan, but the concept holds true.
Because these sponsored plans are offered as an employee benefit, and often-times offer matching provisions to incentivize employees, they are a hugely popular way for people to get exposure to the investment world.
However, although employer-sponsored plans are a fantastic benefit, they are only as effective as the investments held within them. This poses a challenge to the average employee who doesn’t know which funds to choose.
In order to gain a better understanding of how to invest your 401k, let’s break down how the accounts work.
401(k) plans, along with other company-sponsored retirement plans, were created to allow employees to save and invest for their retirement. And since very few companies offer pension plans anymore, the government set up guidelines that would incentivize employers and employees to contribute.
The first tool – that you’re probably already familiar with – is the contribution matching provision. With this rule, companies are allowed to match employee contributions to their 401(k)s. Normally the employer will match up to a percentage of the employee’s salary:
Example: An employer may match 100% of employee contributions up to 4% of the employee’s salary
On top of the matching provisions, 401(k)s also have tax benefits. Contributions into a traditional 401(k) are done on a pre-tax basis, meaning they are taken out of your paycheck before you pay taxes on them.
Then, your account is able to grow over time without paying any taxes on the increase in value. The only caveat is that, when you decide to pull money out, you have to pay income tax on the entire amount withdrawn.
Some 401(k) plans also have a Roth provision that allows you to put after-tax money into the 401k. The growth in the account still happens tax-free, and you are not taxed on the withdrawals since you have already paid taxes on that money.
Now, there is a common misconception that all 401(k)s are the same and that the money one person puts in their account will do the same thing as the money their coworker puts in theirs. This is far from true.
A 401(k) is just an account that applies the aforementioned tax rules to your money. You must decide how to invest the money within the account. Most employers will have a list of investment funds that are able to be held within their plan, and employees select what portion of their contribution they would like to go to each fund.
This is where most people get confused, and potentially pick the wrong investment funds for their situation.
Target Date Funds
Thankfully, most investment companies offer “target date” funds that make this selection process easier. There will normally be multiple funds with a range of dates like Retirement Target 2050, or Lifecycle 2035. The number at the end is the approximate year that you wish to retire.
These funds are invested in a way that traditionally makes sense for someone with the corresponding time to retirement. A 2050 fund will be more aggressive and mostly invested in equities since that person has 30 years until retirement. A 2030 fund will have more conservative investments.
For employees that have little-to-no investment experience, these target-date funds offer a great way to allocate your investments in a way that probably fits your situation well.
Individual Fund Selection
Now, as you continue to work and contribute to your retirement plan, you may start to accrue a large account balance. At this point, you may want to diversify your account so that all of your money isn’t in one fund.
If that’s the case – or if you like the idea of having more control over your fund selection – you are normally able to pick individual funds as investments within your 401(k). Your employer must offer a sheet or webpage with information on each fund so that you are able to make an informed decision.
If you decide to go this route, the most important thing you can do is to make sure you pick a well-allocated mix of funds. That means that, at a minimum, you want to have U.S. small, mid, and large-cap funds, an international fund, and maybe a bond fund if you are getting closer to retirement.
Studies have shown that being well allocated is far more important than individual fund selection, so you want to make sure that your money is sufficiently spread out.
Once you’ve picked your individual investments it’s important to check in from time to time to make sure the allocation still looks like how you planned it. Asset classes tend to move in cycles, meaning that over time, certain investments will outperform others and you may need to rebalance your funds.
Investment selection within your 401(k) is important, but don’t let it scare you away from investing altogether. Workplace retirement plans are one of the best investment tools offered to us, and we should all take advantage of them if we can.
InvestRx Can Help
If your employer offers a retirement plan and you feel like you could use some more instruction on how you should be utilizing it, or if you want to know how your workplace plan fits into your overall financial goals, you may be a good fit for the InvestRx Financial Roadmap.
With the Financial Roadmap, you’ll meet virtually with an InvestRx advisor. We will cover your current financial situation and your top three goals, and develop custom steps to help you get there.
If you are a business or practice owner, and you want to provide an invaluable benefit to your employees, look at our InvestRx Financial Wellness Programs. These programs fill in the knowledge gap and provide comprehensive financial planning services to you and your employees.
Designed specifically for the busy lives and unique needs of medical professionals, InvestRx integrates an online investment platform with white-glove service with the goal of growing clients’ wealth simply and effectively.
We offer investment accounts and financial roadmapping services, all guided by our team of financial experts, with your goals in mind. If you have questions on how to make the best financial decisions at any point in your career, book a Financial Roadmap or contact an advisor to talk through your options.
Investors should carefully consider the investment objectives, risks, charges and expenses of the mutual funds in their company 401(k) plan. Target date portfolios are generally composed of a mix of underlying funds and are subject to the risks and returns of those funds. The management and the allocation strategy of a Target Date fund does not guarantee that investors’ retirement goals will be met. This and other important information is contained in the prospectus and/or summary prospectus of each fund and can be obtained from the Plan Sponsor, mutual fund company or your financial advisor and should be read carefully before investing.