Making Sense of Your 401(k)
Not sure where to begin with your 401(k) plan? Here are some of the best 401(k) investment strategies for every investor to keep in mind.
For many investors, their 401(k) plan is the backbone account of their investments. Yet many investors mistakenly treat their 401(k) as if it’s a savings account—and that’s not the way to generate growth.
In reality, you have a great deal of control over your 401(k) investments, and that gives you opportunities to grow your money in a way that works for you.
Here’s a look at some of the best 401(k) investment strategies to keep in mind.
What is a 401(k)?
A 401(k) plan, named after a section of the U.S. Internal Revenue Code, is a popular type of tax-advantaged savings plan designed to help people save and invest for retirement. It’s the most familiar form of retirement plan for most people, since it’s a popular retirement offering among corporate employers.
There are two types of 401(k) plan:
In a traditional plan, your contribution is paid from your gross income, thus reducing your taxable income and qualifying the contribution as a tax deduction. You pay taxes on the contributions and profits when you make withdrawals in retirement. A Roth plan takes deductions from after-tax income, which means you’ve already paid taxes on the income and won’t get taxed again when you make withdrawals during retirement (not all employers offer this option).
Either way, when you sign up for a 401(k) plan, you agree to have a portion of your paycheck paid directly into the investment account. Your employer matches the contribution or a percentage of the contribution. Within the plan, you get to choose from a number of investments.
This is where strategy comes into play.
401(k) Investment Strategies
Think of your 401(k) plan as a container for various investments. Most employers stick to conventional investments, usually mutual funds. Some employers are starting to offer exchange-traded funds (ETFs) within their 401(k) plans, but it’s still uncommon.
That said, you have a lot of options within those funds, and plenty of strategies for how to grow your money in a way that works for you. Here are some of the best 401(k) investment strategies to keep in mind.
Know Your Risk Tolerance
As with any form of investing, it pays to know your risk tolerance.
In general, risk tolerance can be broken down into:
- Very conservative
- Very aggressive
Very conservative investors are extremely cautious and averse to losing any money, even if it might earn long-term gains. Very aggressive investors are quite willing to take risks and have high returns expectations, which means they’re comfortable with a highly volatile portfolio—think 90% stocks. Most people fall somewhere in between.
In practical terms, risk tolerance describes the amount of money you can afford to lose before you cut your losses and sell, which is a product of your comfort level and your age. Unfortunately, many plan managers craft 401(k) plan options based on types of investments, which makes sense as a grouping but doesn’t help someone who doesn’t know how to choose a strategy.
Start by filling out a risk tolerance questionnaire. From there, you can look into strategies based on your risk tolerance. The more stocks in your portfolio, the riskier it is.
Know Your Fund Types
Once you know your risk level, you can get familiar with the fund options available in your 401(k). Keep in mind that even if all the options are mutual funds, these come with significant diversity—funds run the gamut from conservative to aggressive and everything in between.
All the major financial funds use similar wording and group mutual funds as:
You may also see conservative or aggressive funds. Conservative funds are the safest of the lot, with slow but predictable growth primarily derived from high-quality bonds. Value funds are in the middle of the risk spectrum and invest in stable but undervalued companies that pay regular dividends. Balanced funds are also moderate and rely on value stocks and safe bonds with a few more risky equities thrown in for growth. Aggressive funds are highly aggressive and could get you the next big thing or the next big disaster—either way, they’re willing to give it a try.
Last but not least are target-date funds, which are diversified funds that attempt to maximize your investment value by a specific date. That way, you transition from an aggressive strategy in the early days to a conservative strategy as you near retirement.
Understand Asset Allocation
As you can see, all of these funds add or negate risk based on their unique mix of assets. As such, it’s important to know your way around asset allocation, which simply means spreading your investments across multiple assets to balance risk and reward.
Your ideal asset allocation is based on three things:
- Your risk tolerance
- Your goals
- Your time horizon
Basically, if your goals with your 401(k) are a lot like your other investment goals, then the asset allocation in the plan should look pretty much the same as your other investment accounts. However, if there’s a critical difference in goals, such as a larger time horizon on a 401(k) compared to a taxable account, then your asset allocation should reflect this.
Make the Most of Your Retirement Investments
Ultimately, your 401(k) investment strategies should be a reflection of your unique goals as an investor. Keep in mind that while a 401(k) is the backbone account for many investors, you’re not at all limited to investments within the account—and you can achieve a lot of growth by investing in other areas.
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