For most people, the easiest way to start investing is through their 401k plan at work. In fact, you may already be enrolled and contributing without knowing it.
But if you aren’t, you have two steps that you need to accomplish:
- Choose how much of your paycheck to divert to your 401k
- Select a fund (or funds) to invest in
Let’s break down both questions.
Make Sure You’re Getting the Full Employer Match
The very first step in optimizing your 401k is figuring out whether your employer offers to match your contributions up to a certain limit.
For instance, my company will match 100% of my contributions up to a limit of 6% of my salary. So if I put a dollar in, so do they. If I put $100 in, so do they. They keep matching my contributions until I’ve contributed an amount that equals 6% of my paycheck, then they stop.
This is free money and failing to contribute enough to take full advantage of it is like taking a paycut.
The employer match is probably the best investment return you’ll ever receive. When you invest $100 in the stock market, it can take years for it to turn into $200. With the employer match, it turns into $200 instantly. An immediate 100% return is insane.
With most employers, there are requirements of how long you must stay with the company before you fully own your employer’s contribution. This is called being “vested.” It usually works in stages. At my company you are “fully vested” (you own 100% of your employer’s contributions) after 3 years, but a certain percent of the contribution becomes vested after year one and year two.
Just keep that in mind when switching jobs. This is one of the reasons why it’s good to always look for at least a 20% raise when switching jobs. Not only does the extra money offer some consolation if you hat the new job, but you might be leaving money on the table if you leave your current employer and aren’t fully vested.
Increase Your Contributions Until You Hit the Limit
This is an extremely powerful strategy. Once a year or once a quarter, or whenever you get a raise, go increase the percent of your income that you’re contributing.
The results really add up over time. Let’s illustrate.
We’ll assume that you’re making $50,000 a year and never get a raise your whole career. You put 6% of your paycheck into your 401k and get a 6% employer match. Let’s assume your money earns a 7% annual rate of return.
Here’s what would happen over the course of a 40 year career:
Congratulations, you’re retiring a millionaire. If you had only managed a 6% rate of return, you would have fallen just shy. But it’s nice to know that it’s possible to become a millionaire never making more than $50,000 if you invest faithfully.
Now let’s look at what happens if you increase your contributions each year. So in year one, you contribute 6% of your salary. In year two you contribute 7%, etc. up until you hit the contribution limit. Here’s what that looks like:
That’s quite the difference.
It’s worth mentioning that this scenario is a little tough to pull off as shown because by the end you’re contributing almost $20k and living off just $30k. But probably what will happen is that your income will actually increase over time. So you’ll get a 3% raise and you’ll increase your contributions by 1% until you hit the limit.
At any rate, retiring with $2.5 million having never made more than $50,000 a year is bonkers.
One last note is that if your company doesn’t have 401k options, it’s probably better to just get the full employer match and to invest anything extra in an IRA you open yourself. Once the IRA is maxed out, you can come back and start contributing to your 401k again.
Find the Lowest Cost Stock Market Index Funds Available
When it comes to investing, you want to set it and forget it.
You don’t want to be spending tons of time dealing with this stuff. And you certainly don’t want to be constantly tinkering with your investments chasing higher returns. Or buying and selling trying to time the market. Greed and fear are what cause people to buy high and sell low, which is the opposite of common sense.
By far the best investment vehicle that I’ve ever found for “set it and forget it” investing is an S&P 500 or total stock market index fund (more info on the difference between S&P 500 and Total Market here).
Personally, I like index funds that invest in the total stock market. But the best index fund offered at my work is FXAIX, a Fidelity fund tracking the S&P 500 that has a 0.015% expense ratio.
Speaking of expense ratios, you should be looking for the lowest one possible. And do a quick check to make sure the fund doesn’t have any hidden fees. As I explain in the post below, investment fees can silently eat away your wealth building potential:
In general, when I’m looking for a fund to invest in with my 401k, I look for a low expense ratio and the following key terms:
- S&P 500
- Total Market
- Total Stock Market
The presence of one of those terms is a good clue that you’re on the right track.
If There Are No Good Index Funds, Target Date Funds Are Fine
What is a target date fund?
These are funds that let you passively shoot for a certain retirement date. You pick a fund based on the closest date to your planned retirement (e.g. you’d pick the “Target Date 2050” fund if you plan on retiring in 2049). The fund starts you off with a high percentage of your money invested in stocks, then gradually transitions you to a more conservative allocation with more bonds.
The nice thing is this happens in the background without you doing anything.
It’s been my experience that target date funds generally have slightly higher expense ratios than traditional index funds, but pretty good expense ratios compared to other offerings.
I don’t like the fees, and I prefer a more aggressive investment strategy, but there’s nothing “wrong” with target date funds. If they’re the best thing your employer offers, no big deal. The employer match is more than enough to make up for any shortcomings associated with target date funds.
Consider Your Asset Allocation If You’re Older
When you’re younger, you can get away with being more aggressive in your investments.
You have time for the market to bounce back if it crashes (and it will crash). You also are making regular contributions which will help smooth the ride.
Finally, you probably don’t have a lot invested in the first place. A 30% loss on $10,000 is $3,000 bucks. Get over it and keep contributing.
But the later you are in your investment career, the more money is at stake and less time exists to bounce back from losses.
In order to protect your wealth, you want to keep some of it in a less volatile asset class than stocks. This helps shield a portion of your money from big losses, but it also forces you into a “buy low, sell high” transaction known as rebalancing.
For a very nerdy deep dive into asset allocation, be sure to check out this post:
What should you be doing with your 401k? Well, after a few simple interventions, you shouldn’t be paying much attention. You can set it and forget it.
To get there, here are the steps you want to think about:
- Make sure you’re contributing enough to get the employer match
- Increase your contributions annually (ask HR if this can be done automatically)
- Find a good low cost S&P 500 or total stock market index fund
- If you can’t find a good index fund, Target Date funds are fine
- Think about your asset allocation if you are older or close to retirement
It’s tempting to chase top performance, but you can’t control your returns. You’re much better off focusing on how to increase your income so that you can increase your contributions.