401(k)s For Dummies
Knowing how to build your 401(k) retirement plan; devising investment strategies; and making the most of your plan all help to financially secure your path to retirement. During economic difficulties, you may be tempted to tap into your 401(k) funds, but most often, you're much better off financially if you can leave the funds alone. And your 401(k) management duties don't end when you retire; you still need to invest and spend wisely.
How to Build Your 401(k)
You want the money in your 401(k) retirement account to grow; so, to build a comfortable nest egg, you need a smart strategy. Use the tips in the following list to guide you as you make decisions about your 401(k):
Save in a tax-deferred retirement account as soon as you can, to get more bang for your investment buck.
Start by saving just 1 percent of your pay if that's all you can afford.
Save for retirement even if you think it's too late. It's never too late.
Save at least the amount your employer matches, otherwise you're throwing money away.
Aim to put away 10 percent of your income for retirement each year; increase your savings rate each time you get a raise.
Aim to build a nest egg that's at least 10 times your annual pay when you retire.
Remember that Social Security won't be enough to finance your retirement. Even with a traditional company pension, you'll likely have a gap to fill with your own savings.
401(k) Investment Strategies
You usually have some say in how the money in your 401(k) retirement account is invested, even if your employer manages the 401(k) account. If you're the sole decision-maker, the following tips on how to invest your funds are even more important:
Come up with a plan. Know what you're doing and why: Don't invest blindly, hoping that it'll all come out well in the end.
Establish realistic expectations, and then pick funds that have the potential to meet your goals. Learn from others, but build the portfolio that's right for you.
Remember that higher risk doesn't guarantee a higher return.
Avoid funds that have dramatic up-and-down swings, particularly if you're nearing retirement.
Invest in a mix of asset types, because no one knows which investments will be hot at any point in time.
Find a professional to help you choose the best investments.
Get the Most Out of Your 401(k) Retirement Plan
If your employer offers a 401(k) retirement plan and makes contributions to it on your behalf, you have a leg up in retirement investing. The suggestions in the following list can help you get the most from your 401(k) plan:
Contribute enough to get the full employer matching contribution.
Use education tools and retirement planning aids from your employer or plan provider to help develop and track your retirement plan.
Plan jointly with your spouse to get the maximum advantage from both your retirement plans.
Take any company stock your employer gives you, but don't invest your own money in it. Remember Enron.
Roll your retirement money directly into a new tax-deferred account when you change jobs. Don't cash it out.
Don't take a hardship withdrawal or loan unless absolutely necessary.
Taking Money Out of Your 401(k) Early
Make taking money out of your 401(k) retirement account your last option. The consequences of early withdrawals from your 401(k) hurt your current tax situation and your future investment potential. Keep the points in the following list in mind as you contemplate dipping into your 401(k):
Calculate how much tax you'll owe on a hardship withdrawal before you withdraw the money. You'll owe income tax, plus, likely, a 10 percent early withdrawal penalty if you're under 59 1/2. Your employer withholds some taxes, but you need to make up the rest.
Remember that a $10,000 withdrawal at age 35 will result in a loss of more than $210,000 by age 65, assuming a 9 percent investment return.
Withdrawing money to help buy your first home can be a good investment decision, particularly if you do it early in the year, when the tax break from home ownership helps offset the additional tax you pay on the distribution.
If you borrow from your 401(k), try to continue making new contributions while repaying the loan, to limit damage to your final nest egg.
Don't take a loan if you're likely to leave your employer before repaying it. Any unpaid loan balance will likely be taxable when you leave.
Managing Your 401(k) When You Retire
Finally you're reaping the benefits of contributing to your 401(k) for all those years. As you start taking money out instead of putting it in, use the advice in the following list to keep your nest egg healthy:
Develop a strategy to deal with the taxman, because you will have to pay taxes when you take money out of the plan.
Consider keeping at least one-third of your money in stocks during your retirement years. Converting everything into fixed-income investments leaves your money vulnerable to inflation.
Don't ignore inflation. What costs $10,000 the first year you retire will cost $20,328 in your 25th year of retirement, assuming a modest 3 percent inflation rate.
Establish realistic investment return expectations (such as no more than 6 to 8 percent) during your retirement years. Don't be lured into high-octane stocks that may fizzle.
Plan to withdraw no more than 6 to 7 percent of your retirement account each year to reduce the potential of running out of money.
Consider selling your home and investing the proceeds, thus converting your home from an income consumer into an income generator. (You can rent a smaller place.)
Get professional advice, because you can't afford to make big mistakes at this stage of your life.