A couple of weeks ago, I asked my email subscribers for their biggest WTF questions when it comes to money. (Not on my list yet? Sign up in the box over there! >>) I got some amazing responses, but this one really stuck out:
“How do I make money in my 401(k) when I’m only offered certain investments?”
As I was responding to this reader’s email personally, I realized that he’s not the only one with this question. This is probably the most common question I get, hands down, from people of all ages. I mean, it’s one of the biggest reasons I started ReisUP in the first place! Since 401(k)s and 403(b)s are offered through employers, have certain tax benefits, and are socially deemed “the go-to retirement savings vehicle”, they’ve become most people’s primary investment account. But no one really knows how they work. So I decided to share my response to his question here to help all of you.
**Note: This is a long-winded piece, but it’s chock full of super useful info. I highly recommend reading it in its entirety. However, if you’re pressed for time, here are the main takeaways:
- Make sure you choose a variety of appropriate investments. Decreasing your chances of losing money is one way to inadvertently make more money in your 401(k).
- Choose lower fee funds. Being mindful of costs is another way to make more money.
- Max your employer match. It’s free money on top of your normal pay and a guaranteed way to earn more money for retirement.
- If you’re not happy with your company’s retirement plan, say something about it! Ask them to change it. The worst that can happen is they say no.
- Consider contributing some of your retirement dollars to a traditional or Roth IRA for more flexibility.
Without further adieu...
How do I make money in my 401(k) when I’m only offered certain investments?
First things first, you have to contribute, or put money into your account, and you need to start as early as possible. As the old saying goes, “you’ve gotta have money to make money”. The beauty of these types of investment accounts is that they allow you to start small and slowly add money over time to take advantage of the power of compound interest. If all you can afford to put away every month is 100 bucks, hey that’s still $1,200 a year. And over 40 years at a 6% return rate, your account could be worth over $200k when all you put in was $48k ($1,200 per year x 40 years).
The next thing you need to recognize is that just because you have limited investment options doesn't mean that they're bad investment options. When it comes to 401(k)s, there are definitely some plans that are better than others. But at the end of the day, companies are obligated to offer "suitable" plans that are in their employees' best interest.
The quality of your plan does play a role in your investment success. But there are three key factors somewhat in your control that will ultimately affect your ability to make money in your 401(k). Those three key factors are:
1. VARIETY OF CHOICES
You should have some version of an equity fund, bond fund, and cash/money market fund available to you. Those are the basic asset "buckets", if you will. Most plans will offer a few different types of each. For example, types of equity funds you'll often see are a large-cap growth fund, 500 fund, mid-cap blend fund, small-cap value, international fund, and global or world fund. I posted a short video that breaks all of these down a while back.
For bonds, you'll usually have a choice between maturities like short-term, intermediate-term, and long-term bond funds. You may also see corporate bond funds like investment grade and high yield funds, as well as government funds like income funds and US Treasury funds.
And the cash options may be "disguised" as money market funds or stable value. Note that a T-bill fund is considered a cash-equivalent fund as well.
On top of all of that, plans are increasingly offering what are called target date or lifecycle funds. These usually have some year (2030, 2050) in the name, and the investments they hold are meant to change over time as you get closer to your retirement date. I'll be doing a video and blog post (read: strongly worded rant) all about those in the near future, so hang tight if you need more info.
Why does the variety of options matter?
Three words: asset allocation and diversification. I’ll dive into each of those topics in more depth in the future, but in essence, your asset allocation is represented by which asset buckets you have your money in (70% stocks/30% bonds, for example). Diversification involves choosing different varieties of investments within each asset bucket. For example, you might “fill” your equity bucket with a fund that invests in large US stocks, another that buys small US stocks, and one more that invests in international companies.
Investing in different asset classes and different types of assets within each class is important because it helps lower the potential risk of your portfolio. Different asset classes typically move in different ways in response to various economic factors. In technical terms, that means they are uncorrelated. For example, when the economy is growing like a weed, stocks tend to do well but bonds lag. When the economy weakens, “hard” assets like gold and real estate often do better than stocks. It’s important to invest in a variety of assets so that, hopefully, a portion of your portfolio is always “in favor”. This also typically helps limit your downside, or how much money you can lose at any one time, because the “in favor” assets’ positive returns offset the “out of favor” assets’ negative returns.
Moral of the story? Investing in the right mix of funds can inadvertently help you make more money in your 401(k) by limiting the amount you could lose.
This is a big one. When you see how much these funds charge (1%, for example), it seems like a small number. But those fees compound over time and reduce your potential return. John Oliver gave an awesome analogy recently:
I recommend thinking about them like a hurdle - the higher the hurdle, the higher you have to jump just to clear it. Same goes for fees. The higher the fee, the better the fund has to do just for your account to breakeven. Your investment profit lies above that hurdle.
The main fee you’ll hear people talk about is called the expense ratio. This is essentially all of the fund’s annual fees bundled into one. It’s the ongoing cost of investing in that particular fund, and it takes a bite out of your return every year (it’s the hurdle mentioned above).
Most actively managed funds (where pros like me are picking certain stocks) will have expense ratios somewhere in the 0.75% to 1.5% range, though I've seen them significantly higher (so be careful!). There are much cheaper options called index funds that charge as little as 0.05%. For more info on index funds and how a "measly" 1% difference can cost you over $200k in the long run, check out this video lesson.
On top of the expense ratio, there may be additional “hidden” fees called loads. These are essentially sales fees where the person that sells/enrolls you in the fund gets a kick back in the form of a commission. These can be big, and you should absolutely look out for them. Load fees come in a few flavors:
Front-end loads: These are sometimes called initial loads as well. If a fund has one, you’ll be charged a certain percentage right off the bat simply for buying into the fund. That means the amount you actually invest will end up being lower by that amount. For example, if you invest $10,000 in a fund that has a 5% front-end load, $500 (5% of $10,000) will go to the broker/sales agent, and only $9,500 will end up invested in the fund. That’s $500 fewer dollars to compound for you over time.
Back-end loads: These come in a couple of flavors. The first is a called a deferred sales charge, sometimes a contingent deferred sales charge (CDSC). This a fee that you’ll be charged if you sell shares of the fund too soon after purchasing them. This fee also goes into the broker’s pocket. The second type is called a redemption fee. This is a charge paid to the fund itself for pulling your money out. It’s meant to prevent people from day trading the fund or trying to time the market.
You can find information about the fees your available funds charge in your plan’s Summary Plan Description. If you don’t have one, ask your plan administrator or HR Department for a copy. You can also type the fund name into the “quote” box at morningstar.com, then select “expenses” to see that fund’s fee info. If you’re spreadsheet savvy like me, I highly recommend making a quick table of your available investment options in a program like Google Sheets or Microsoft Excel. Grouping all of the important information in one place may take a little time, but it can be a really eye-opening exercise. Good ol’ pen and paper works just fine too.
The generally accepted rule of thumb? If you have two funds available to you that are similar in terms of what they invest in and their total long-term return, you should strongly consider investing in the fund with the lower fees. I know that a 1% difference may not seem that large right now, but over the course of your working years, it could mean $200k less in your pocket. Don’t believe me, look at this graph.
Moral of the story? Being mindful of fees is one way to inadvertently make more money in your 401(k).
3. EMPLOYER MATCH
As an added incentive to employees, many employers now offer a match. It’s called a match because your employer will “match” every dollar, or a percentage of every dollar, that you put into your retirement account up to a maximum. I explain the employer match in depth in this video post, but here are the three common structures:
Set dollar amount: Your employer will match you dollar for dollar up to, say, $3,000 per year. How to get it? Contribute $3,000 to your account, and they’ll throw in an extra three grand.
Dollar for dollar up to % of your income: Your employer will match you dollar for dollar up to, say, 3% of your income. If you’re making $40k per year, 3% is $1,200, so you need to contribute at least $1,200 in a year to get the full match. Anything above will not be matched.
X% of every dollar up to % of your income: Your employer will match a certain portion of every dollar you contribute up to a max percentage of your income. For example, a common structure is 50% up to 6%. That means they’ll match half of your contributions up to 6% of your income. If you’re making $40k per year, 6% is $2,400 and your employer will match half of that, or $1,200. Notice that this setup requires you to contribute more to your account to get the same match as the previous structure.
One word of caution when it comes to matching: Beware the vesting schedules. It may seem like your employer offers a great match. That is, until you dig a little deeper and realize that you don’t technically “own” any of that money until you’ve worked at the company for a certain number of years. For example, perhaps none of your match money will “vest” (become yours) until you’ve been an employee for 3 full years. That’s called cliff vesting, and it means you’ll forfeit all of those match dollars if you leave before the 3-year mark. Other companies have graduated vesting where a portion of the money vests each year until 100% is yours. And some offer immediate vesting where the match money becomes yours immediately. Make sure you know your plan’s vesting schedule. Otherwise, you may risk losing that money if you leave your company too soon.
If you need help understanding your match or calculating how much you need to contribute to max it out, check out page 13 of my DIY Guide for Your Retirement Account. If you’re already on my list, you should’ve received it via email in September. If you’re not on my list yet, get your copy here!
Moral of the story: MAX YOUR MATCH. Even if you don’t really like the rest of your plan. It’s a guaranteed way to “make money” in your 401(k).
WHAT IF I'M NOT HAPPY WITH MY PLAN?
Does the variety of investments leave a lot to be desired? Are the funds offered all “expensive” when it comes to fees? You may be able to change that!
Story time: I was shocked to find that all of the funds offered in my 401(k) were relatively high fee. There wasn’t a single fund with an expense ratio below 1%. It was unacceptable! So I brought it up to the powers that be at the office and guess what, a few months later, we were all rolled into a significantly cheaper, better plan. Voila!
Another option is contributing to an IRA in addition to your 401(k). For example, let’s say your employer offers a match, but you’re not thrilled about the investment options in the plan. You could contribute enough to max the match, then contribute any additional retirement savings to an IRA where you have more flexible investment choices. Just be aware that while a 401(k) allows you to contribute up to $18,000 this year, an IRA caps contributions at $5,500. So if you’re planning to contribute more than $5,500 annually, you’ll need to figure out how to divvy up those contributions between accounts. A Roth IRA also has income limits, whereas 401(k)s and Traditional IRAs do not.
The 401(k) and IRA strategy is also a viable option if you want to contribute money to a Roth (after-tax) account but your 401(k) doesn’t offer it. You could contribute money pre-tax to your 401(k) and after-tax to a Roth IRA. For more info on the differences, check out this video post.
That’s a TON of information, so let’s recap the main points:
Make sure you choose a variety of appropriate investments. Decreasing your chances of losing money is one way to inadvertently make more money in your 401(k).
Choose lower fee funds. Being mindful of costs is another way to make more money.
Max your employer match. It’s free money on top of your normal pay and a guaranteed way to earn more money for retirement.
If you’re not happy with your company’s retirement plan, say something about it! Ask them to change it. The worst that can happen is they say no.
Consider contributing some of your retirement dollars to a traditional or Roth IRA for more flexibility.
* * * * *
I know it may seem like you have no control over your 401(k), or that you’re just “stuck” with whatever your company offers. I hope this post shows you that’s not really true. You have a lot more say than you think, but you can only exercise that control if you fully understand the factors at play.