When it comes to your retirement, the most important thing you will ever do is contribute to some type of retirement account like a 401(k). Understanding how these accounts work, especially in your later years, can be crucial. Most people get the concept of pre-tax contributions: traditionally, when the money from your paycheck is diverted to your 401(k), it goes in before it is taxed and the investments grow on a taxed deferred basis. You’ll pay all those taxes later when you make withdrawals.
Making the initial decision to contribute to your 401(k) is half the battle. Once you’ve done that, however, you’ll need to make a few more decisions. First, you’ll need to select how you want your contributions to be invested. If you’re young and have decades until retirement, then the investments you choose should be aggressive. However, as you get older, you’ll probably want to dial back the risk level. Many 401(k)s now also offer an auto-escalation feature. Here, the percent of your pay that gets deposited into the account increases yearly. Having your contributions on autopilot is a winning strategy, especially if you’re using auto-escalation.
One area of 401(k)s that can get confusing is the difference between current allocation and future contributions. Let’s assume you are in your mid 50’s, have been contributing to your 401(k) for many years, and have built up a solid nest egg. Diversifying the account balance is must, but how you invest new contributions might be different. Sometimes investments that have declined in value are viewed as an opportunity. So, while you may not want to expose your life savings to a bear market in stocks, you may be willing to put the next $100 that gets withheld from your paycheck to work in something that is out of favor temporarily. It’s important to know the difference between your “current allocation” and “future contributions”.
As I mentioned above, if you’re young, it is usually prudent to keep your 401(k)’s current allocation and future contributions aggressive. Luckily, there are usually a healthy variety of investment options for the aggressive investor. Unfortunately, that’s not always the case for conservative ones – I’ve seen 401(k)s with only one or two bond funds. One feature that is becoming more popular with theses accounts is known as a “brokerage link.” Here the investor has the option to move a portion of his or her 401(k) balance into a separate account where there are actually thousands of investment choices. If most of your life savings is in your retirement account, and you’re nearing retirement, this helpful tool can be a huge benefit.
Whether you are just getting started or have been contributing to your 401(k) for decades, knowing the features and tools available to you can make a huge difference. To learn more, the first place to start is with your human resources department. If, after that, you are still looking to learn more, contact a Certified Financial Planner®.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.