Ice cream is my weakness. Seriously, I love it. If it’s in the house, I’m going to eat it. Shamelessly I’ll admit to more than one occasion when I’ve eaten ice cream for breakfast (but to be fair, it was coffee flavored, so it should be acceptable). Ice cream has little chance of surviving in my house.
But if N doesn’t buy it and it’s not in the house, I don’t miss it. Nine times out of ten I won’t drive to the store to get it. (well, maybe six times out of ten). I’ll just eat something healthy like a lame apple.
So how does this have anything to do with your 401(k) you must be asking. When you choose to defer your income (save) in your employer 401(k) plan, you are giving up the chance to spend the money. The money is taken out of your paycheck before you even get it. Because you never actually received the money, you were never able to spend it. You’re protecting yourself, from yourself.
In a previous post I talked about ten steps for pre-retirement planning. Often the largest segment of a pre-retiree and a retiree’s savings is accumulated in a 401(k) plan. Mainly because it’s easy. You check a few boxes upon being hired, and you go on your way.
The problem is most don’t do the research to understand what the checked boxes mean for our retirement. The good news is by making a few simple decisions regarding your 401(k), you will set yourself in the right direction. Take a look at my suggestions below:
Step 1 – Decide How Much You Want to Contribute
Looking for a simple answer? Save at least up to the amount of your company match. If your company matches your contributions up to 6%, you should be saving at least 6% (this is literally a 100% rate of return on your money. Where else can you get a 100% rate of return?).
Now the bad news, you still probably aren’t saving enough. A benchmark should be to save 10% or more of your salary. And once you reach 10%, I’m going to push your goal up to 15%.
People generally don’t save enough for retirement. The earlier you start and the more you save, the more likely you are to be in a better situation in the future.
Step 2 – Decide if You Want a Traditional 401(k) or a ROTH 401(k)
Remember when you were a little kid, and you’d ask your parents for a lollipop. And they would say, you can have one now…. OR, if you wait until tomorrow….. you can have 2!!
I obviously took the lollipop now. I was going to worry about tomorrow, tomorrow.
Well picking between a traditional 401(k) and a ROTH 401(k) is similar. Do you want the tax benefit now, or do you want it later.
If you contribute to a traditional 401(k), you will receive a tax deduction during the year you contribute to the plan. You will be taxed on the money when you withdrawal it from the 401(k).
With a ROTH 401(k), you forego the tax deduction now. However, when you withdrawal the money from your ROTH 401(k) (assuming qualified withdrawals) the money is tax-free!
So I ask you again, do you want to lollipop now… or later.
Step 3 – Decide Your Risk Tolerance
I try to keep things simple. Do you want your investments invested low risk, medium risk, or high risk (we’ve already talked about this here)? The higher the risk, the more likely you are to make money over the long run. But the higher the risk, the more likely you are to lose money over the short-term.
Your investment risk tolerance is going to be determined by your asset allocation. Your asset allocation should be determined by many factors including your age, income, net worth, income need, other investments, etc.
Step 4 – Decide if You Want to Pick Investments Yourself, or Have Someone Else Do It.
Now that we know how safe or risky you want to be, we can begin to pick your investments. Most 401(k) plans have two general strategies. First one is do it for me. Second strategy is I’ll do it myself.
- Do it for me – Most if not all 401(k) plans have an investment option known as a lifestyle fund. Lifestyle funds are diversified portfolios that are designed for employees who don’t know what they are doing, don’t have time to do it, and/or want a professional to do it for them. Typically you put all your money into one of these and let do its thing (it’s OK if you only have 1 fund here, because it is inherently diversified inside of it).
- Self Selection – Personal control, specific expertise, fun. There are many reasons some employees choose to pick their own investments. In addition to the lifestyle funds discussed above, 401(k) plans will offer individual mutual funds employees can pick. If you are picking your own funds, you likely don’t need me to explain this anymore, so I will move on.
Step 5 – Stay Out of The Way
Ready for this… don’t look at it. Well, don’t look at it too much. Studies have shown that the average investor under-performs the general market by 3.0% or more over the long run. Why? Because making sound investment decisions, consistently, is difficult. Investors often get in the way and make bad long-term decisions based on short-term emotions.
A simple strategy for staying out-of-the-way is to pick a lifestyle fund as discussed above.
None of the information in this document should be considered tax advice. You should consult your tax advisor for information concerning your individual situation.
Asset allocation or diversification do not guarantee a profit or protect against loss.
Image courtesy of Stuart Miles at FreeDigitalPhotos.net