How Much Should You Contribute to Your 401(k), and How Should You Invest It?

By Markets Fool.com

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Source: 401kcalculator.org via Flickr.

As a financial writer, I get a lot of questions from friends and family about their 401(k) plans at work. The most common questions:

  • How much should I contribute so I have enough for retirement?
  • Will my 401(k) be enough?
  • How should I allocate (invest) my money?

Many people don't understand 401(k) plans very well, or the investment strategy they should use. However, investing in a 401(k) should be simple. Here's a quick set of guidelines you can apply to your 401(k) so you can enjoy worry-free growth and a worry-free retirement.

How much to save: the bare minimum
At the absolute minimum, you should contribute enough that you're taking full advantage of your employer's matching program. For example, if your employer is willing to match all of your contributions up to 4% of your salary, then under no circumstances should you contribute less than this amount. Doing so is the same thing as agreeing to a salary reduction -- you're simply refusing part of the compensation you're entitled to.

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Employer matching is how many people turn relatively small amounts of their salary into a large retirement nest egg. Let's say you make $60,000 and your employer matches up to 4% of your salary. So you're contributing $2,400, but $4,800 is going into your account. Over a 35-year career, assuming 2% annual salary increases, you could end up with a $900,000 401(k), assuming 7% average annual returns (a historically conservative estimate). With good market performance, you could even get to a million or more.

Try to save more
While this sounds like a lot of money, and it is, it may not be enough to sustain the lifestyle you want throughout your retirement. Based on the often-used "4% rule" of retirement, using our preceding example, a $900,000 retirement would safely produce $36,000 in annual income in retirement. Withdrawing any more than this much increases the chances you'll eventually run out of money. Even when factoring in Social Security, it might not be enough to have the kind of retired life you want.

Fortunately, you can save more than your employer is willing to match -- a lot more, in most cases. For the 2015 tax year, the IRS allows you to choose to have up to $18,000 of your compensation deferred into your 401(k), and the figure goes up to $24,000 if you're over 50.

One popular strategy is to increase your contributions by 1% per year until you hit the maximum amount you're comfortable with saving. And a small increase could make a big difference. Returning to our example, consider how small increases in elective contributions can make a huge difference in the long run.

Your Contribution (% of Salary) Employer's Contribution Account Value After 35 Years
4% 4% $900,869
5% 4% $1,013,478
6% 4% $1,126,087
7% 4% $1,238,686
8% 4% $1,351,305

Note: Assumes $60,000 starting salary and 2% annual salary increases. Also assumes 7% annual investment returns.

Of course, if you want to have more control over your investments, doing your extra saving in an IRA is a good alternative. In an IRA, you can buy any individual stocks, bonds, or mutual funds you want, so they're a popular choice among more "active" retirement savers. However, under no circumstances should you contribute less to your 401(k) than your employer will match.

How to choose your investments
This shouldn't be nearly as difficult as people tend to make it out to be, as it's hard to do a bad job of investing using 401(k) funds.

When selecting your investment allocations, just remember that you want exposure to U.S. stocks, foreign stocks, and fixed-income investments like bonds.

The bulk of your account should be in U.S. stocks, unless you are close to retirement age, in which case you may want to be a little more conservative and make your portfolio more bond-heavy. The actual stock funds you select (large-cap, small-cap, growth, value) are a matter of personal choice, but the fact is that all of them should deliver comparable (and good) performance over the long run.

Foreign exposure is important because it offers you some protection against currency fluctuations and weakness in the U.S. markets. It can also be a good way to get exposure to economies -- namely, emerging markets -- that have the potential to grow faster than ours.

Finally, bond funds are generally more stable and tend to do better during recessions. This is why they tend to make up a large portion of retirees' portfolios, as they provide low-risk income but don't focus on capital appreciation.

The exact percentages are up to you, but a good rule is to take 110 minus your age and allocate that much money to stocks. For instance, I'm in my 30s, so I have about 80% of my retirement funds in stocks and 20% in fixed income.

Worry more about how much you save than what you invest in
Over long periods of time, stocks tend to outperform any other asset class. So don't stress too much about which particular stock funds you choose to invest in.

The absolute best thing you can do in your 401(k) is to invest as much as you're comfortable with and set a reasonable investment allocation. If you do that, your nest egg will take care of itself.

The article How Much Should You Contribute to Your 401(k), and How Should You Invest It? originally appeared on Fool.com.

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