When you’re in your early twenties and you’ve just landed that first salaried gig with benefits, retirement tends to be the furthest thing from your mind. On one hand, it’s something that you know you should be savings towards, but on the other, it feels as though you have plenty of time to get your house in order. Additionally, many people didn’t have the privilege of taking personal finance courses in school, which means that retirement investment options can feel extremely foreign and overwhelming.
One of the most common retirement plans we hear about is the 401(k) plan. It’s offered as part of a benefits package by many employers so we sign up because someone told us that we should. We choose the most conservative investing option. And then, we let it sit without ever truly knowing how it works or how we can better optimize our funds to ensure financial comfort in our golden years, which is almost as bad as not investing at all.
When it comes to investing, knowing how your investments work, and establishing a solid game plan is a major part of building wealth. Sadly, according to a 2019 ValuePenguin survey, nearly two-thirds of Americans are confused about 401(k) plans and how they work. As a result, we set out to demystify the 401(k) with some help from Bankrate reporter and financial analyst, James Royal. So let’s begin with the basics.
What is a 401(k)?
“Basically, a 401(k) is an employer-sponsored retirement plan,” shared Royal. “And what it does for you is it allows you to grow a contribution that you make as an employee.”
401(k) plans have great tax benefits
“You can grow that (contribution) over time on a tax-deferred, and sometimes, tax-free basis,” adds Royal. “It’s a better way for you to grow retirement savings. You’re not paying taxes every year on your gains and it kinda keeps the government out until retirement.”
You’ll want to avoid touching the funds until you reach retirement
When it comes to your 401(k), “You have to kind of lock your money up until retirement, which is defined as 59-and-a-half years old,” Royal advised. “You have to lock your money up in this account and you can’t take it out or you’ll be charged some bonus penalties and taxes.”
Some employers will match your contributions, which means “free” money
“The extra special advantage about it though is that many employers actually match some of the money that you put in. So if you contribute to say, four percent, they might throw in another three or four percent of your salary for free,” said James. “And so it’s a, it’s a great way to, to help roll up that money, especially if your employer is helping you on top of it.”
You can choose how to invest your 401(k) money
“You can invest 401(k) money in whatever your plan offers. Typically, there’ll be stock funds. There might be bond funds. There might be cash funds. There might be funds that invest in specific types of stocks or specific types of bonds,” Royal explained. “It really depends a lot on the fund and what is specifically offered by your plan. But basically, what you do is every paycheck, you can have a certain amount of your salary set aside that just goes into those one or two or three or however many funds that you have selected at the start of the plan. Then that money goes in and just buys it automatically, you don’t have, once you set that up, you don’t have to go in and make any other choices.”
You can be an aggressive or conservative investor
“Let’s define what it means to be aggressive and conservative. When we say that, really what we’re talking about is how much you have allocated to stocks and how much you have allocated to bonds. So, if you have a seventy or eighty percent of your portfolio allocated to stocks, that’s more aggressive than if it’s seventy or eighty percent allocated to bonds.”
Your investing style should be based on your age
“Whether you’re too aggressive or too conservative has a lot to do with when you need the money. If you’re sixty-five years old, a sensible allocation between stocks and bonds is going to be different than if you’re twenty-five or thirty-five,” said Royal. “If you’re sixty-five and you need the money soon, you don’t want to rely much on stocks. You can have some stocks, but you don’t want to have as much as you would if you were younger. Stocks fluctuate a lot more whereas bonds are going to produce more steady income. There’s really not gonna be a lot of fluctuation over time so they’re going to be more steady cash generators.”
In your younger years, you’ll want to be a more aggressive investor
“When you’re younger, twenty-five to thirty-five you’ve got literally decades before you’re going to be able to access that money. You want it on the highest performing asset that you can get; the highest performing investment that you can get, and that really is stocks. The US stock market is really the most impressive wealth-building device ever created. You want to be invested with as much of your money as possible for as long as possible. So, a lot of advisors say, ‘Hey look you’re young. You’ve got decades left before retirement. You need eighty, ninety, maybe even one hundred percent of your investments in stock and really, that’s probably not too aggressive if you’re young and you can ride out.”
If you’re unsure of how to split your investments, the rule of 100 can help
“My personal opinion is that when you’re young, you probably ought to be almost all stocks and just adding overtime, ” Royal explained. “But one rule that a lot of advisors use is called the rule of 100. And what that means is you take your age and you subtract that from 100 and that’ll give you your allocation to stocks. So, for example, you’re thirty-five years old, that means you should have sixty-five percent in stock.”
You shouldn’t base your investing strategy on current events too much
“In a lot of ways, good investing is about focusing on the long term and not trying to worry too much about what’s going on in the short term, Royal explained. “You want to have a strategy that fits you for the long-term. In general, when stocks are down, you want to buy them. If you use something like the rule of 100 to figure out what your allocation should be, well what happened in the most recent market dip is that bonds didn’t really do a whole lot. They kinda just a flat like they normally would. I mean there were down a little bit but they kinda just stay flat, but stocks really really dipped, at least for a while. So what an allocation rule like that would allow you to do is say, ‘Oh, look hey my allocation to stocks is way below where it should be and I need to shift some money from bonds to stocks. So by picking an allocation like that in sticking to it, it helps you buy stocks when they are cheaper and how to sell them a little bit when they sort of go above.”