So, I just want to start this post by saying I’m not new to having a 401(k) or investing. But I will say that I was far from knowledgeable when I first started.
Even today, I know, in theory, the volatility in my account is par for the course, and contrary to advice from my therapist to stop logging in and checking every day, I still find myself doom-checking my retirement accounts. One month, it’s down $3k; the next month, it’s up $6k. What the heck is going on in there?!
I guess the obvious answer is just market volatility, but honestly, it got me thinking back to when I started investing… you know, back when baby Yaya had no clue what she was doing or what choices to make. Seeing all the ups and downs had me questioning whether I (meaning me, who made these choices years ago) had chosen the right investments. And I knew going into my next 401(k) I wanted to make sure I understood, what I was getting myself into (figuratively and financially). So, I found myself wondering… how do you understand the investment options in a 401(k)?
So, I decided to do some research and make a blog post about it.
Let’s talk 401k 101 Research: How to understand the investment options in your 401(k).
Click the links below to jump to a topic in the post:
Oh, and if you are interested in seeing my portfolio, 401k investment options, and how I researched and made my choices, read on until the end.
So first, let’s go over what a 401k is. A 401k is a tax-advantaged retirement account
offered by most employers.
Tax-advantaged means you can save dollars for retirement before Uncle Sam takes out income taxes. Another good thing about a tax-advantaged account is that it lowers your taxable income, meaning you could save on taxes just by saving for retirement.
Retirement account means you are setting aside money to be used in retirement. So, you can't touch this money before the retirement age. Well, you can, but you can’t do it without a penalty. If you took this money out before retirement, you’d have to pay taxes on it.
Offered by an employer means… an employer offers it. It’s an employer-sponsored plan. It can only be established by an employer. So… yeah.
You should also remember that sometimes, there’s a waiting period before you can participate or contribute to your employer's plan. When you join a company, they probably give you some brief info about the company 401(k) program. And the 401(k) is usually offered with one of the many financial providers. TD Ameritrade, Principal, Empower, Fidelity, ADP, etc.
Your employer might also offer something called an employer match. This means they will contribute money to your 401(k) account, matching a percentage of up to a certain percentage of your salary. In other words - it’s free money.
For example, they might match 100% of up to 5% of your salary. So, if you made $100,000 a year, your employer would match up to $5,000. So if you put in $5,000, your employer would contribute $5,000 as well, giving you a total of $10,000 in your retirement account.
There’s also something called a vesting period. According to Principal, “You become fully vested in a retirement plan when you have worked for your employer for a certain length of time outlined in the plan's vesting schedule. Suppose your employment with the company ends before you are fully vested. In that case, you will only be entitled to a percentage of the money contributed by your employer based on the vesting schedule outlined in your plan.”
Umm, yeah, simply put, any money you put in is yours to keep. But if you leave the company before the vesting period is complete, you give up any employer-contributed money that isn’t vested back to the employer. It’s your employer's way of keeping you loyal to the company and making sure, you can’t skip away scott-free with the ‘free money.’
But anyway, once you are able to participate, you can sign up, go online, start contributing, and
then be confused by all the confusing freaking options you have to start investing in your portfolio.
In case it’s unclear, contributing to your 401(k) is only part of what you need to do. For your money to begin growing, you need to invest your contributions. Otherwise, you just have a fancy employer-sponsored mattress to store cash in.
You invest by selecting your preferred investment options inside the 401(k). Think of the 401(k) as a basket; you have to choose the eggs to go into your basket. These are the investments, and this is how you build a portfolio. Who knew all those years hunting for easter eggs would pay off as a life lesson?
So, let’s walk through the options together and see if we can figure this out.
Assessing your risk tolerance
When selecting investments, there are a few things you want to consider. One of these is your risk tolerance. Meaning are you a conservative or aggressive investor? There is such a wild ride in my portfolio because I have a semi-aggressive investment approach. This means my account is made up of aggressive assets like stocks, which are more risky and prone to fluctuations. On the other hand, conservative assets like bonds or guaranteed interest accounts (I assume these are similar to CDs) are prone to less fluctuation and are considered less risky.
Based on your risk tolerance, you may want a mix of conservative and aggressive "eggs in your basket." This is called diversification. If you consider yourself risk-averse, you can lower your risk factor with conservative assets. If you’re not risk-averse, jack up the risk with more aggressive assets.
Researching your investments
When you begin researching your contributions, you want to look for something that lets you
“Select your Investments.” Now, here’s where it might be confusing as a newbie.
You can’t just search AAPL or MSFT to add to your 401(k). Why would it be that simple? What you are going to see is a bunch of investment funds. These funds each hold different stocks, bonds, and/or other investment vehicles of varying proportions that are monitored and managed by fund managers.
From my experience, most providers offer some kind of pre-built portfolio or fund options based on risk tolerance or, in most cases, they offer Target Date Funds.
With target date funds, the investments in the portfolio are selected based on a model
that will change the allocations over time, usually from aggressive assets to conservative assets,
as the model approaches the target retirement date.
Selecting your investments
In your 401(k) offering, you might see a number of target date funds available.
The simplest option is to select a target date fund closest to your anticipated retirement date and invest your contributions there. Or, if you want to invest by risk tolerance,
you can assume the target date funds that are past the current date or close to it will be the most conservative option.
If you’re like me and have a while before retirement, you can afford to be more aggressive
with your investment. This is because you have time on your side; trust me, you don’t want to lose out on the compounding or compound interest you could gain over years and years of investing.
And just a note: you don’t have to select the target date fund closest to your anticipated retirement date, but again, it’s still a good choice if you want this to be simple, easy, and over with.
Once you have made your selections, confirm them and then sit back and congratulate yourself because you are now officially invested in your 401(k).
Thanks for reading to the end of this post! There’s a ton more information that I can show you about 401(k) investment options. So, if you are interested in videos that follow along as I make my 401(k) investment choices and discuss:
Taking an in-depth look at the composition of an example target date fund
Comparison of different target date funds
How to understand fees associated with managed funds or;
How to avoid paying unnecessary fees in a 401k that could cost you 1000 of dollars
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Thanks for reading, and don’t forget to check the helpful resources in the comments below.
Good Luck!
-Yaya
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