401(k) plans offer a variety of investments from which to choose.
Potentially the most rewarding — but also the most intimidating — part of managing your 401(k) plan is deciding how to invest the money you’re putting into your account.
That’s because the investments you select make a major difference in how quickly your account balance may increase or decrease in value and the income your plan will be able to provide after you retire.
What the choices are
Your employer, who is the plan sponsor, picks a financial services firm as plan provider. The sponsor selects the investments to be offered in the plan from among those available through the provider.
At a minimum, you can expect three distinctly different investments, each of which puts your money to work in a way different from the others and exposes you to a different level of risk. For example, there may be a stock fund, a bond fund, and a capital preservation fund.
In reality, most 401(k) plans offer a range of choices within these three categories, each of whose investment objectives and other characteristics vary. As an example, there might be six stock fund choices, variously focused on companies of different sizes, international companies, growth companies, and value companies.
Some of the plan’s funds may be passively managed index funds, which track a particular market index, such as the Standard & Poor’s 500 Index or the Russell 2000 Index. There may also be a balanced fund, which owns a mix of stocks and bonds. The relative proportion of stocks to bonds is noted in the fund’s prospectus.
Some plans also offer a set of target date funds. You select the one whose date — 2020, 2025, 2030, 2035, 2040, or 2045 — is closest to the year you expect to retire. These funds of funds allocate your money to a diversified portfolio of individual funds that’s appropriate for the amount of time you have to accumulate assets. Over time, the mix is gradually modified from a focus on seeking growth to a focus on providing income.
You may also find a set of target risk funds. They are also funds of funds that select a combination of stock and bond funds that expose you to a certain level of risk— aggressive, moderate, or conservative — and therefore provide the potential of a certain level of return.
What is automatic (default) 401k investment?
If a plan sponsor chooses to enroll employees automatically in a 401(k), it chooses a default investment for all participants. It must be a set of target date funds, a balanced fund, or a managed account.
If you’re automatically enrolled, you have the right to stick with the default investment or choose a different investment or investments from among those offered through the plan. The same is true of the rate at which you contribute. You may prefer one that’s higher or lower than the 3% rate that’s the initial default percentage for many automatic enrollment plans. The primary limitation is that most employers require you to contribute at least a minimum — often 1% — to participate. In some cases, there may be upper limits — such as 15% — as well.
Should you choose target funds?
The appeal of target funds is that they reduce the stress of choosing how to invest your contributions. They also provide a level of professional oversight and, in the case of target date funds, a commitment to revising the allocation according to the guidelines established in the prospectus.
The funds are also transparent, which means you can check a fund’s prospectus for how it is invested, the pace at which it plans to reallocate and fees.
There may be drawbacks, though. The fees tend to be higher than on a self-selected combination of individual funds because of the additional layer of management. The principal value of target date funds is not guaranteed at any time, including at the target date, so you could have less than you expected — or need — at retirement.
If your employer matches contributions by adding additional tax-deferred money to the accounts of participating employees, it’s smart to contribute enough to qualify for the full amount to which you’re entitled. It’s often 50% of what you contribute to a maximum of 5% or 6% of your pay, though plans differ.
While any money you contribute to your 401(k) is yours from the start, you have to work for your employer for a certain amount of time, called a vesting period, to be entitled to its contributions when you leave or retire. There are various vesting schedules, to a maximum of six years, so be sure to check which one your employer follows. It might make a difference if you consider changing jobs but don’t want to forfeit part of your account.
If your employer doesn’t match and provides limited investment choices, you may want to consider contributing less to your 401(k) and putting the maximum in an individual retirement account (IRA). That will give you more flexibility to invest as you choose.
How To Pick The Best And Safest Investments For Your 401k? by Inna Rosputnia
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