Your 401(k) is often one of your best tools for creating financial freedom. You can use this account to help fund your retirement by investing up to $19,500 every single year ($26,000 each year at age 50). That is more than triple what you can put into an IRA. You can even take a loan against your 401(k) to buy real estate. In some situations, you may be able to receive a company match which means you can get free money for investing in your future.
Hi, my name is Kevin L. Matthews II, top 100 financial advisor, and best-selling author and in this guest post, I’m going to teach you about how to pick your investments inside of your 401(k).
What’s a 401(k)?
In February 2020, right before the pandemic hit the stock market there was a record number of 401(k) and IRA millionaires according to Fidelity at more than 400,000. But what is a 401(k) and how do you go about choosing the right investments?
The 401(k) was created when Congress passed the Revenue Act of 1978. That law included a new tax rule called “Section 401(k).” In the 1980s, 401(k) accounts began gaining traction and became one of the main ways for people to fund their retirement. Prior to this, most companies offered pension plans which gave people the option to receive a portion of their salary after they retired. Today, you almost only find these for state employees like teachers, policemen, and firefighters.
A typical 401(k) allows you to invest in the stock market tax-free and when you are ready to retire you can take the money out. But there are a few things that you want to know:
- A 401(k) is only offered by your employer. In most cases, unless you own your own company, you cannot open your own 401(k). If your current job does not offer a 401(k) you may want to consider an IRA, check out this post here.
- There are rules that come with a 401(k). As I mentioned earlier there is a limit to how much money you can put in each year, this limit does tend to go up every few years. You also cannot withdraw the money without penalty until age 59 1/2 unless you meet certain criteria. Due to the CARES Act, some of this criteria has been updated to reflect the coronavirus pandemic. You will have to pay income taxes on the amount of money you withdraw from the 401(k).
- You can only invest in the options that your employer gives you this means that you are generally restricted to mutual funds. You’re not able to invest in individual stocks like you would in an IRA. I like to refer to this as investing with “what’s on the menu.” If your 401(k) is a restaurant then you’re only allowed to order (invest in) the options they have in front of you. Just like you can’t go to McDonald’s and order a Whopper, you won’t be able to invest in shares of Tesla in your 401(k). (..unless you work at Tesla)
How should I choose my 401(k) investments?
Before choosing, the most important thing is finding out what your investment mix should be. The Wall Street term for this is “Asset Allocation.” I want you to think of it like a personality test. Your investment mix is the combination of stocks and bonds that you will have.
I tell my clients to look at it like this: Stocks are going to be the petals and bonds are going to be like the brakes on a bicycle. Stocks are going to help you to grow your wealth over time and push you forward a lot faster. Bonds however, are going to cushion the blow when the market is bumpy. On this journey to financial freedom you are going to need both and the closer you get to retirement the more you will move toward bonds than stocks.
Not having the right investment mix means that you could be taking on too much risk. This could cause you to work much longer than you expected if the market falls just before you retire. This happened to thousands of people in 2008. On the opposite end, if you take on too little risk, your money will not grow to a level that allows you to retire.
Every 401(k) is going to have a list of stock funds and bond funds. There are two ways to find out the amount of stocks versus the amount of bonds that you need.
Take a Risk Tolerance Quiz
First, you can take a quiz called a Risk Tolerance Questionnaire. This will give you a more precise method of narrowing down your investment options. (Here is one you can use)
Use Rule 110
Second, you can use the Rule of 110 where you take 110 minus your current age.
Here is an example: I am 30 years old. So taking 110 – 30 = 80. 80% of my 401(k) should be in stock funds, 20% should be in bond funds.
*Note: You’ll want to come back and revisit this each year and make adjustments.
Target Date Funds
If you don’t like doing the math or want to come back and make adjustments every year, you’re in luck. That is exactly what Target Date funds were made for.
Most 401(k)s will have an option that says something like “Target 2045” or “LifeCycle 2050.” The year is the target date and these funds will automatically move between stocks and bonds as you get closer to those dates. If you’re looking to retire in 2045, select the 2045 fund or the year that is closest.
Fund Types: Large, Mid, and Small-Cap
If you prefer the DIY approach here’s how you can select those funds.
In the example that I mentioned earlier, 20% of my 401(k) should be in bonds. Most 401(k)s have a bond fund option or something called a stable or income fund. You can put the full 20% into these areas.
The stock fund options are a bit broader. In most cases, you will see a Large Cap Fund, a Medium (or Mid) Cap Fund, a Small Cap Fund and sometimes you may see an international fund too. Each of these has its own advantages and disadvantages.
A large-cap fund will typically invest in large well-known companies. This will usually include companies like McDonald’s, Wal-Mart, and Apple. These funds are usually more stable over time. Of the three (large, mid and small-cap) large-cap is considered the safest, most reliable, and consistent option.
This group of funds is made up of medium-sized companies. Right now, this could include companies like Peloton and Wyndham Hotels. Generally, these funds will make more money than Large Cap funds over time but take on more risk.
As you can guess by now, Small Cap funds are made up of smaller companies. This could include companies like 1-800-Flowers. Small-Cap funds are generally known for being the riskiest but over time they tend to outgrow mid and large-cap funds.
In my example we know that about 80% of my 401K should be in stocks. We could choose to split your money pretty evenly between these like this:
Large-Cap – 27%
Mid-Cap – 27%
80% STOCKS TOTAL
Closing Investment Tips
This gives you a strong way to grow your money from all parts of the stock market. If you want to be more reserved you may choose to put more of your money into the large cap fund. Doing so will mean that your money won’t dip as much when the market is down. If you want to be more aggressive you may want to put more in the small cap fund.
What if I do not have access to a 401k?
Sahirenys already has you covered, check out this post here.
That’s it! Now you have everything you need to choose the investments inside of your 401(k).