Knowing the right way to manage your 401(k) investments can help you achieve the retirement of your dreams. Image Source: Getty Images
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The single most common question I get asked by my friends and family is, "Can you tell me what to do with my 401(k)?" or something similar. While I'm always happy to oblige, with a little basic knowledge, it's relatively easy to know what to do with your 401(k) by yourself. With that in mind, here are three 401(k) tips that could mean thousands of extra retirement savings dollars in your account.
Try to select cheaper investments
In your 401(k) plan's information booklet or on its website, each of the investment fund choices will have a number listed as the "expense ratio." This tells you the annual cost of investing in the fund, expressed as a percentage of your assets. For example, a 1% expense ratio means that you'll pay $1 for every $100 you have invested in the fund each year.
Expense ratios can vary considerably, and depend on the nature of the fund, the mutual fund company, and the size of your company's 401(k) plan. In general, the larger your plan, the cheaper the fees will be.
While your 401(k) limits your investment options to a basket of mutual funds, there can be considerable variation among expense ratios, so it's worth checking to see if there are cheaper options within your plan that have the same investment objectives.
To illustrate why this can earn you thousands, let's say that your 401(k) plan has three fund options labeled "large-cap growth" with expense ratios of 0.40%, 0.75%, and 1%. If each fund's stocks produce 9% annual returns, in line with historical averages, take a look at the difference these fees can make over long time periods assuming $3,000 annual contributions.
Of course, there's more to mutual fund investing than just comparing expense ratios. However, the point is that when it comes to choosing funds with substantially equal investment goals, lower fees can make a big difference.
Know the right kind of funds to choose
The single biggest factor in choosing 401(k) investments is knowing how much of your money should be in stocks and how much should be in bonds -- a concept known as asset allocation.
As a general rule, I suggest using the "110 rule," which says that if you subtract your age from the number 110, that's the percentage of your retirement savings that should be in stocks, with the remainder in bonds. For example, I'm 35, so this rule says that I should have 75% of my 401(k) in stocks and 25% in bonds.
You can adjust this rule higher or lower based on your own risk tolerance, but it's a good place to start. The main takeaway is that the majority of most investors' 401(k) savings should be in stocks, in order to take advantage of the superior long-term growth potential it provides. Then, as you get closer to retirement and capital preservation becomes more of a priority, you should gradually shift your money into bond funds.
Using your knowledge about expense ratios, pick out a few of your plan's best stock and bond funds and allocate your assets accordingly.
A target-date fund may be the best move for you if...
As a final tip, if you prefer to take a hands-off approach -- that is, researching and selecting investment funds doesn't sound appealing to you -- it's completely fine to select one of your plan's target retirement funds. Many plans offer these, and although they may be called something else (a "lifecycle fund," for example), these are the investment choices that have a year in the title, such as Vanguard Target Retirement 2050 Fund.
These funds are intended to do all of the work for you. A target-date retirement fund will automatically invest your money in an age-appropriate combination of stocks and bonds, and will gradually shift the allocation away from stocks as you get older. Here's a more thorough description of target-date retirement funds if you're interested.
One word of caution: Be sure to check the expense ratio of your target-date option and compare it with your plan's other investment choices. If the expenses are comparable, there's nothing wrong with essentially putting your savings on auto-pilot. On the other hand, if the target-date option is significantly more expensive, you'll probably be better off spending a few hours and selecting your own funds.
Bonus tip: Do your homework
401(k) investing doesn't need to be complicated, but it's also not a great idea to just "set it and forget it," unless you choose a target-date fund as your sole investment.
As I mentioned in the allocation section, it's important to gradually shift from stock-based to bond-based funds as you get closer to retirement. You don't need to make changes too often -- maybe add a couple percent to your bond allocation every two years -- but it's certainly important to do. If you're 35 and set your portfolio to 85% stocks, the last thing you want is to keep that allocation forever, and have a stock market crash devastate your portfolio just before you plan to retire.
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