How Employers Invest Your Money in 401(k)s—Is It Good for You?
Create a 401(k) That Benefits You
One easy way to understand 401(k)s is to imagine a basket of stocks, bonds, and exchange-traded funds (ETFs) where employers and employees make monthly contributions for tax breaks and employee retirement growth. Every month, a portion of your paycheck goes into a tax-deferred fund that grows with the power of compounding. This means that your profits won't be taxed over time, and you may deduct the contributions to lower your annual tax bills. You may also take out that money penalty-free after you reach 59 1/2 years of age and only pay taxes on withdrawals.
However, this may become a problem if an employer assigns an administrator or a financial firm to choose stocks on your behalf. It seems that many Americans have been experiencing this. Even if your employer offers you up to three investment portfolios, you may have trouble choosing if they don't educate you on the benefits of each one. If you don't have any preference, your employer might assign you a default selection of stocks and bonds to your 401(k) that won't really fit in with your investment goals.
Although money lost in a stock market crash might come back when the market auto-corrects over time, you could easily overlook high investment fees and permanently lose tons of money by the time you retire. The expense ratio is a good way to look at how much you are paying to invest in a stock—something your employer might overlook. Here's an example:
Let's say you are 30 years old with $10,000 savings in your 401(k), and you make annual contributions of $8,000 until you are 60. If you factor in a return of 8 percent on stocks and 2 percent on bonds over the next 30 years with an expense ratio of .75 percent, you could miss out on approximately $100,449 as investment fees. To help avoid losing out, this investment fee calculator from a fiduciary called Blooom manages 401(k) accounts using artificial intelligence (AI). Fiduciary firms and advisors are bound by law to work in your best interests, but do your research to ensure the best approach and fit for you.
How to Fine-Tune Your 401(k)
CNBC refers to a Fidelity Investments report finding that the average 401(k) balance tanked by 19 percent to $91,500 at the onset of the pandemic. Some Americans had to dip into their life savings, while others had to make changes to their lifestyle. If you want to keep your 401(k) safe during a recession and help it grow faster during market booms, you may want to start with the fundamentals.
Step One: Budget Allocation to a Carefully Designed Portfolio
How much are you able to invest? Could you afford market volatility at this age? When do you hope to reap the profits? A financial advisor should ask you these questions before deciding how much to invest in stocks, bonds, and gold, for example.
In order to find and choose the right proportion of stocks, you may want to connect with an in-house vetted fiduciary advisor from SmartAsset, one of the most-used financial websites in the U.S., or get virtual access to advisors via Blooom. The latter uses one of the few robo-advisors that cater to retirement accounts and are well suited for small- to medium-size 401(k) or IRA accounts.
Keep in mind that your budget allocation should be based on your risk appetite and personal aspirations. If you don't understand your current 401(k) portfolio yet, now would be a good time to align it with your financial goals. You also need to ensure that you do not deviate from the percentages you have allocated for stocks, bonds, and alternative investments, as this would defeat the purpose of creating a financial plan based on your risk appetite and goals in the first place. Since your portfolio is unique to your finances and goals, sticking to your financial plan could offer steady growth even during market upheavals.
Step Two: Rebalance Your Finances
Once your asset allocation is in place, you might have to manage it by frequently rebalancing your stock investments to stay on course during market changes. This is a popular technique used by investors that entails selling high and buying low. After all, market movements may change the set proportion of shares in your 401(k) every day as one stock grows and another one shrinks.
One simple example of rebalancing would be selling a particular stock that grew in value and using that liquid money to buy more of a stock that saw a decline. This way, you could stay within your budget allocation. Rebalancing every quarter could be effective for wealth creation strategy.
Step Three: Match Up and Avoid High Investment Fees
Employer-matching is a simple concept. Basically, if you earn $100,000 a year and your employer offers 100 percent matching for up to 4 percent of your annual income, the total employer contribution for that year would be $4,000. That would be free money without any tax constraints.
The contribution limit for 2021 currently stands at $19,500, with additional catch-up contributions of $6,500 for those over 50. So, if your employer offers a matching contribution, you should try to max out and invest to the highest possible cent per dollar.
As noted earlier, investment fees are a percentage of the money you pay to invest in stocks. Unfortunately, this could grow with your investments and become a fortune you might never see. Picking the right stocks with low-investment fees may be tedious, as well.
As a robo-advisor, Blooom offers an edge in efficiently managing 401(k) or IRA accounts. Their AI bots scour the market for low-fee, quality stocks and gets rid of any high-fee investments. As of March 1, 2021, their clients' median expense ratio stood at a mere 0.11. The best thing about their services is that they offer a free analysis, which could paint a vivid picture of what your retirement would look like if you optimized your current 401(k) account with low-fee stocks or ETFs.
