There’s no denying that 401(k) plans are great resources for saving and investing for retirement. You spend your career contributing to a 401(k), with the idea that in retirement, you can live off those funds and let finances be an afterthought as you enjoy the fruits of decades of labor. Any contribution to a 401(k) plan is a good thing, but there are ways to be efficient with your investing to ensure you’re maximizing your contributions. It mainly comes down to being intentional with your investment selections.
It’s expensive to be hands-off
One of the downsides of a 401(k) is that investment options are provided to you; you can’t invest in any stock you want like you can with IRAs. One investment option you’re likely presented with is a target-date fund. Target-date funds are titled with a year in their name (like Target-Date Fund ABC 2050) because they’re based on your projected retirement year. As you near retirement, these funds automatically reallocate the holdings to become more conservative.
The problem is that since these funds are actively managed, they tend to be much more expensive than index funds. According to Vanguard, the industry average for target-date funds is 0.49%, meaning you’ll pay $49 annually per $10,000 you have invested in the fund. And though the percentage may seem small, it can easily add up to tens of thousands of dollars paid in fees over the course of a career.
It’s possible, however, to receive the same benefits as a target-date fund (diversification, risk adjustment, etc.) without paying target-date fund fees.
It’s all about allocation
One thing you’ll notice about target-date funds is that most are “funds of funds,” meaning the target-date fund itself consists of other funds. One way to get around paying the high fees often associated with target-date funds is by investing directly into the funds it holds. You can make a solid 401(k) portfolio by investing in four types of index funds: large cap, mid cap, small cap, and international.
How much of your portfolio you have in each largely depends on your age. For people in their 20s or 30s, the allocation may look like the following:
Large cap: 60%
Mid cap: 10%
Small cap: 10%
For someone in their 40s or early 50s, an example could be the following:
Large cap: 70%
Mid cap: 10%
Small cap: 5%
For someone in their mid-50s or closer to retirement, the allocation may look like this:
Large cap: 80%
Mid cap: 5%
Small cap: 5%
These aren’t concrete percentages by any means, but they’re a good benchmark to use as you decide what allocation works best for you and your risk tolerance.
Adjust your risk as you age
Smaller-cap companies tend to come with more risk than larger-cap companies, so you want to invest in those funds sparingly as you age. The idea is that as you get closer to retirement, you should minimize your risks and focus more on preserving your money than growing it. If you’re younger, you can take more risks because you have time on your side to recover if things go sideways. If you’re a few years from retirement, a market downturn — which normally impacts smaller companies more — could be detrimental in general, but especially so if a good portion of your portfolio is in smaller-cap funds.
Target-date funds are more expensive because they automatically do the reallocating for you, adjusting for your age and time until retirement. By understanding the idea of lessening risk with age, you can manage to do it yourself with few issues. It’s as simple as logging into your 401(k) plan provider’s platform and adjusting your allocation percentages.
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