How much time do you spend planning your 401(k)? If you’re like most Americans, you spend more time planning vacations, instead of planning for retirement. This lack of planning can lead to being ill-prepared for retirement. Luckily, there are a few methods that you can apply to your 401(k) that will ensure a healthy retirement fund. Consistently contributing to your account, being aware of the fees, and understanding your risk tolerance will allow you to maximize your 401(k).
Thanks to the power of compound interest, even small consistent contributions can add up. For example, a 25-year-old who invests $3,000 per year, assuming a net annual 7% return, would end up with a 401(k) balance of approximately $528,000 at age 65. Instead of trying to time the market, invest the same amount each year or month. This is commonly called dollar cost averaging and can be shown in this example.
An investor making $50,000 per year contributes 5% per year into his or her 401(k), which is approximately $200 per month. This investor puts this money into a target date fund every month. The price of the fund fluctuates, but this investor buys the same dollar amount regardless. Dollar cost averaging protects you from the risk of buying in at the wrong time and can lower your average cost per share.
Look At The Fees
Nothing in life is free, including money management. For example, many mutual funds charge a 1% expense ratio to manage the mutual fund. So $100 out of every $10,000 you invest would go to the mutual fund. This doesn’t seem like much, but it can add up over time, and a 1% fee can cost millennials over $500,000 in retirement savings. High fees can significantly lower a retirement portfolio’s balance, which is why it might be prudent to consider lower-fee funds. Many funds that have lower fees are called index funds, which follow the performance of stock market indexes like the S&P 500.
Conversely, most mutual funds are actively managed, meaning that the fund managers aim to have higher returns than the S&P 500 or other indexes. However, around 95% of fund managers fail to beat the S&P 500 over the long run, which is why index funds have become very popular.
Risk tolerance is very important to your 401(k). You’ll have less time to recover from market crashes the closer you are to retirement. Therefore, most investors shift or rebalance their portfolio to more conservative investments like bonds as they near retirement. It’s important to consider the optimal blend of riskier assets like stocks and more conservative ones like bonds for your situation. Usually younger investors are in aggressive investments like stocks and index funds since they have higher returns and have a longer time horizon.
Be sure to monitor your risk tolerance as you age to prevent losing your hard-earned funds to crashes like the one in 2008. Or you could use an investment like a target date fund, which automatically rebalances your portfolio over time. Most major investment companies have target date funds and an example is the Vanguard 2030 fund. So investors that will retire around 2030 will invest in this fund, which will reduce their risk level over time. While this is helpful, it’s wise to consult a trusted financial professional regarding your risk tolerance, investments, and financial goals.
The Bottom Line
A 401(k) can be a great way to build a sizeable retirement nest egg. However, most people fail to properly set up and maintain their 401(k) accounts, which has led to a retirement crisis. Fortunately, this can be easily prevented via simple financial education, like the 401(k) best practices mentioned here. By having steady 401(k) contributions and being aware of fees and your risk tolerance, you’ll be able to create a significant balance that will provide for you in your golden years.
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Darren Wurz is a co-owner and financial planner at Wurz Financial Services, an independent, family-owned and operated financial services firm dedicated to helping its clients transition from their working life to a comfortable retirement with confidence. Darren received his master’s of science in financial planning from Golden Gate University and also holds the CERTIFIED FINANCIAL PLANNER™ (CFP®) designation. He operates the Northern Kentucky/Cincinnati office of Wurz Financial Services and is an active member of the Covington, KY rotary club, the Northern Kentucky Chamber of Commerce, and the Covington Business Council. To learn more about Darren, connect with him on LinkedIn.