With pensions fading away and 401k's becoming one of the major reliance's of retirement planning everyone wants to know the best setup for their 401K. While the best setup is generally what you mentally feel comfortable with saving for retirement, we can offer a few general tips and guidelines to help you choose. Please remember higher risk has potential for greater gains and losses, while lower risk is the opposite.
Portfolio Selection
Typically all 401K plans offer the following categories when choosing funds to place your money in: growth, capital preservation, income, balanced, and sometimes stock in the company for which you work.
Capital Preservation Funds
Capital preservation funds are designed to preserve your savings principal. They typically invest in government securities with a predictable rate of return. This is the lowest risk category with the lowest returns. The returns have been known to under perform inflation, which means you could lose buying power in any given year. For example, if the economy inflates at 4% and you get a 3% return on your savings, then you have 1% less buying power than the previous year. Simplified, a TV costs $100 this year and after inflation of 4% the TV costs $104 ($100*4%). Your savings account with $100 had a 3% return leaving you with $103 ($100*3%).
Income Funds
Income funds usually diversify your money into various bonds and are typically for long-term gains. While the exposure to any type of loss is very rare, it is not impossible. With the low amount of risk that comes with income funds you will generally see a lower return then the average of the New York Stock Exchange.
Balanced Funds
Balanced funds try to get the best of all worlds by diversifying between international stocks, domestic stocks, and fixed income securities. These funds are very reliant on the fund managers to choose the right mix to protect and grow your savings. If you are unsure which percentage of your funds you wish to devote to the various other funds, then you may want to consider a balanced fund. Before placing your money into one of these funds, please ensure that you research the funds management history and current manager.
Growth Funds
The "riskiest" of all investments is the growth fund, but it also has room for unimaginable returns. Over the long run these funds typically out perform the stock market because they are invested in international bonds and markets, small cap stocks, and emerging markets of developing nations. It is not uncommon for the annual returns to follow a pattern as such: -73%, 115%, 50%, -33%, 83%. These funds are subject to a variety of factors that some funds are not such as: oil prices, civil wars, and medical epidemics.
Company Stock
Everyone remembers the Enron scandal where thousands of employees lost all of their retirement savings in less than a year. While this is not always the case with companies and some may be very well and dependable, please keep situations like the above-mentioned in mind and take proper precautions to protect your finances. I do not recommend placing more than 10 percent of your savings portfolio into your company stock; however, the choice is completely up to you.
Choosing the Right Mix
With so many options it is hard for an individual to make a choice between various funds. Because everyone has different financial needs and situations the worst thing you can do is pick the same options as your co-workers without giving it a second thought. Before placing your money into any of the categories you will want to consider the following:
Years before retirement
How much money you need
Your reaction to sudden market drops
How many years before you retire?
One of the most important factors is how many years you plan to continue working. If you have a long time left to work (over 10 years) then a good idea may be to place the majority of your assets in growth funds. The longer you have left to work the more aggressive you should be while saving for your retirement. As you get closer to your retirement age (less than 10 years) you will want to consider starting to migrate some of your growth funds into balanced or conservative funds so your nest egg has less sensitivity to market drops
How much money do you need?
How much money you need goes hand-in-hand with how many years you have left to work. A lot of financial planners can assist you with determining how much money you should place into your savings each month based off these two factors. You can estimate this yourself by doing the math or using an online financial calculator. I recommend an online calculator or use of a Microsoft Excel spreadsheet to save yourself the time. Here is an example of what the math would look like. Take your expected rate of return on your savings and multiply it against the amount you save each year so that the first year looks like this:
Year 1: $4,000 (your yearly savings) % 1.08 (8%) = $4,320
Year 2: $4,320 (previous balance) + $4,000 (annual addition to savings) = $7,320 * 1.08 = $7,905
Continue to do this formula until you reach the year you desire, there are calculators that can do the math for you. Just type in "retirement calculator" in Google and you are sure to get results.
If the market crashed...would you care?
The #1 determining factor of where people place their retirement savings is mentality. Regardless of what you should and shouldn't do with your retirement fund, if you are not able to mentally handle the results then it is not worth doing. I would never recommend to someone to place all of their money in growth funds if they would not like the idea of losing half of their money in a single month. Whatever you decide to place your money into, please ensure that you are okay with the decision. Remember, it's never a real loss until you sell, any growth fund capable of losing half your nestegg in a year or less is also capable of returning it.
Tax Deferred or Taxed Contributions?
Another important determining factor is whether or not to save with after-tax contributions or before-tax contributions. Unlike regular savings accounts, 401K's have the option putting money into them without being subject to federal income tax. Here is a list of things you should consider before choosing either option:
Your tax bracket
If the money will be used for emergencies
What is your tax bracket now and what will it be?
Generally speaking if you are in a high tax bracket and plan on making less money when you retire than you would want to consider tax-deferred contributions. Tax-deferred contributions are deferred on taxes up until the point when you start withdrawing the money. If you are currently making enough money to be in let's say, the 33% tax bracket, but when you retire you only plan on being in the 25% tax bracket, then you should definitely consider placing your money into your 401k as tax deferred. By deferring taxes until you withdraw the money after retirement in the 25% tax bracket you would be saving 8% on taxes (33%-25%) and on top by deferring you have 33% more money in your fund that can grow tax deferred. If you tax deferred $5,000 a year into your 401k and it grew at 8% a year for 30 years; you're ending balance would be about $611,729.34 which you would draw out in monthly payments that would be taxed at 25% or whichever bracket you fall into after retirement. If you took that same $5,000 dollars but put your money in after tax your final balance for the same scenario would be about $409,858.66, the difference is that you would not have to pay taxes on this money because you have already paid them. You would have about 50% more money in your account after 30 years.
The opposite also holds true. If you are currently in a 15% tax bracket but plan on retiring and being in a 25% bracket, then you may opt to place after tax money into your 401k.
Please keep in mind everyone's situation is unique and that you should find yourself a good financial advisor or planner if you are unsure of which is best for you.
Is this money going to be used for emergencies?
If you are using your 401K as an emergency buffer account for things that ARE NOT: Primary Residence purchasers, Medical Emergencies, and things of this nature and plan on USING it for things such as credit card debt, paying late bills, and other things related, then you will definitely want to take into consideration the 10% tax penalty and tax consequences of making a withdrawal for these things.
If you take a withdrawal on a tax-deferred 401K that is a non-emergency than you will be subject to not only income tax on that money but a 10% tax penalty as well. Please take that into consideration before making any unnecessary withdrawals. Also, you can always get a loan from your 401K but it is not recommended because you lose savings principal to earn interest on and you have to pay it back at an interest rate probably around 8%.
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