How to Optimize Your 401k (And Avoid the Pitfalls)!
For most of my fellow oil and gas friends a 401k is as common as a paid internship, hell most of us could invest in a 401k during our internship. But for some of the young professionals out there, a 401k isn’t as well understood or utilized. Don’t fret if you’re one of these people, you’re more common than you think! After reading this article you’ll know how to take full advantage of your 401k without letting your 401k take advantage of you. As for my savvy oil and gas friends with a “top” 401k plan, read up, you may learn something about that target date fund you’re invested in.
For those of you who don’t know, a 401k is simply a retirement plan with your employer. Within the 401k you can buy or trade anything that’s offered by the investment company holding your retirement. Once you are fully vested you are given full control over the portion of the funds the company contributed to your 401k, even if you leave the company you still own/control all the investments inside your 401k. If you leave your job before you are fully vested then you keep the portion of the funds you contributed to the account but the company you work for will take back their contribution.
The funds you want to put in your 401k can be automatically debited from each paycheck, which works perfectly with the dollar-cost averaging strategy. If you are not already enrolled in the automatic payroll deduction contact HR or investment services to take advantage. This is the best and most convenient option since you never see the money in your personal account, and therefore never have the urge to spend it!
But how much can I contribute? For 2018, the most you can contribute is $18,500 of your money; this does not include any portion the company matches. The $18,500 maximum is strictly based on your contribution.
When can I withdrawal the money I put in? The answer, 59 1/2. If you would like to make a withdrawal before you are 59 1/2 there is a 10% penalty plus any taxes. To avoid the penalty you must meet one of the three criteria;
- Face financial hardship,
- Have medical bills exceeding 10% of your AGI (Adjusted gross income), or
- Become disabled.
The other option would be to borrow against your 401k. You are allowed to borrow half of your 401k balance or $50,000, whichever is less, for five years. There are a few nuances here so consult with a financial advisor beforehand. I’m not recommending this option but if you find yourself in a tough situation, this is on the table.
As I’ve expressed before, try to resist the urge to withdraw any money from your investments so you can maximize the full power of compounding interest.
Generally speaking there are two different types of 401k’s; the roth and traditional. The Roth 401k allows you to pay taxes now so you can grow your investments tax free i.e. you don’t have to pay taxes when you make withdrawals because you pay them the year you make your initial contribution (i.e. with post-tax dollars). The traditional 401k allows you to reduce your taxable income by the contribution amount so you’re not paying taxes on any contributions now, but you will pay taxes when you make withdrawals later in life. To say it in its simplest form; in a Roth 401k you pay taxes now, in a traditional 401k you pay taxes later.
What can I buy with my 401k? Each investment agency is a little different but the majority of 401k’s offer pretty much the same type of investments; some target date funds, mutual funds, index funds and the company stock. Fidelity is the investment company that has my 401k and they offer 23 different investments options. You have the ability to invest any portion of your investment portfolio into any option offered by the investment company, whether that’s 100% company stock or 10% across ten index funds. I’m not saying either of these options are prudent. I just want you to know that you have the flexibility to invest as you please.
What to avoid when investing in a 401k
Now that you know how to invest within your 401k let’s talk about a few things that can inhibit you from reaching your financial goals, or at the very least, slow you down. The two most prevalent things that will prevent your 401k from reaching its ultimate potential are ignorance and fees.
What do I mean by ignorance? Most of you know that you should always take full advantage of a company match.
Example: Exxon matches 7% of Doug’s salary to his 401k. If Doug makes $100,000/yr then Exxon will contribute a dollar for every dollar Doug contributes up to $7,000. Doug is getting $7,000 for free! After Doug puts $7,000 of his own income in his 401k in 2018, assuming no gain from investments, he will have $14,000 ($7,000 from Exxon and $7,000 from himself).
Utilizing a company match may seem pretty intuitive but what about target date funds (TDFs)? According to Fidelity, 96% of large employers use TDFs as their default choice. Why? Because employees kept buying company stock, and only company stock. To help employees diversify without having to think they created the TDF. The concept is brilliant. How many of you are investing in TDFs because the fund automatically adjusts your asset allocation as you get closer to retirement? “It’s so easy I just set it and forget it,” you say.
But what if I told you that a survey conducted by Envestnet and Behavior Associates found 30% of employees thought TDFs provided a guaranteed rate of return (ROR) and 62% thought they could retire when the fund was due (the date selected for the fund example: TDF 2055 has a due date of 2055). Were you like some of these misguided employees? If so don’t feel bad, you don’t know what you don’t know. But making decisions based on pure misconception can have dire effects.
Let me make one thing clear; the only thing a TDF does is adjust the asset allocation of the fund to more conservative the closer you are to retirement i.e. adds more bonds to the portfolio as you reach the due date. However, the exact methodology on how each fund does this isn’t clear and almost no two TDFs are alike. The things the TDFs don’t do is promise a ROR or allow you to retire at a certain date.
While TDFs are easy and convenient, understand what your investing in. Maybe it is the best option but do the research first. Here is an article from CNBC for some more information.
The other piece that limits your portfolios full potential is fees. I have mentioned fees several times before and how crippling they can be to your investment returns. Here is the interactive Vanguard tool from the post Objective View of Stocks, Mutual Funds & Index Funds (Clear Winner?) to show the destructive nature of fees. If you are unsure of the fees associated with a TDF, stock or index fund call the investment company and ask for the documentation breaking down the fees. By law they must provide you with this paperwork.
A great resource for understanding your 401k fees is AmericasBest401k.com. Click on the “Find My Fees” tab and follow the instructions. They will guide you through your current 401k fees, making them as transparent as possible.
How to invest in your 401k
Just like investing in anything else, there isn’t a one size fits all approach. You have to evaluate your risk tolerance and, most importantly, understand the investments your are making. As I said before, ignorance isn’t shown sympathy in the investing world. Regardless of how you choose to invest here are a few tips to help make the most of your 401k;
- Begin contributing as early as possible. Take full advantage of the power of compounding interest.
- Contribute at least every dollar the company will match. If you don’t you are leaving free money on the table.
- Evaluate the fees associated with the stock or fund you are investing in. Are the fees acceptable or detrimental?
- Ensure your asset allocation for your retirement portfolio takes your other assets (brokerage or IRA accounts) into consideration, failure to do so could have your asset allocation out of proportion, exposing you to unnecessary risk.
- If you believe, as I do, that taxes are going to increase then use the Roth 401k; pay taxes now, instead of later when taxes are higher. If you think you’re paying higher taxes now then use the traditional 401k; reduce your taxable income today and pay those taxes later when you make withdrawals.
- A 401k is a employer sponsored retirement account.
- For 2018 the max contribution to a 401k is $18,500.
- You can withdraw from your 401k penalty free at 59 1/2. To make an earlier withdrawal you must meet certain criteria.
- There are two types of 401ks; roth and traditional. Roth you pay tax now and traditional you pay tax later.
- Be cognizant of fees.
- Ensure you understand your investments. Eliminate as much uncertainty as possible through research and questions. Don’t be afraid to pick up the phone and call Fidelity, that’s what they’re paid for!
I hope the above has helped clear some ambiguity around 401ks and their investments options. If nothing else, look at your investments and make sure you understand the fees and what you’re buying into. Ask yourself, “is this the best vehicle to get me to my investment goals?” That being said, I hope all of you will take full advantage of the 401k, as it is a great tool for building wealth. But remember the devil is in the details. Those small fees can add to huge return impairment. These tips will help you grow your nest egg faster and in turn, help you reach your investment goals more quickly.