For most people, a 401(k) is an excellent financial tool which helps them save for retirement without having to pay taxes on either their contributions or their investment gains. While investing in a 401(k) is an excellent idea and an efficient way to build long term wealth, not properly managing the account can be devastating and decrease an investor‚s total potential return. To properly manage a 401(k), several steps need to be taken.
The first step in properly managing a 401(k) is to determine how much to invest. Ideally, the investor should invest as much as they can possibly afford to. The investor is allowed to invest up to $16,500 per year on a tax deferred basis. If they are over 50 years old, the investment allowance jumps another $5,000. For those who cannot afford to invest the maximum contribution, they should aim to invest at least 10% of their gross pay into their 401(k). In some situations, an employer will provide their employees with a 401(k) match. Since it is free money, the employee should always ensure they invest to at least the point where they get the entire match.
The next step in properly managing a 401(k) is choosing the right investment allocation. When signing up for a 401(k), many investors are thrown into certain investment classes based on their age. The investors then never reconsider their investment needs going forward. Each 401(k) investor should check their investment allocation frequently, and adjust it as they age. As a general rule, the younger an investor is, the more aggressive their investment allocation should be. As an investor ages and approaches retirement, more and more of their investment allocation should be shifted towards conservative investments. This is because in the event the market drops off, the older investor has less time to rebuild their portfolio. Regardless of the age of the investor, it is also always wise to diversify their portfolio and have no more than a third of their investments in any one fund.
The third step in properly managing a 401(k) is monitoring performance of the investments. The investor should routinely analyze the performance of each investment and compare it to other investments of similar risk and the overall market. If the investment seems to be falling behind the pace, the investor should consider re-allocating a portion of their investment into a more historically successful fund.