How to Invest in a 401k
So, you have a new 401k? Or maybe you have been working for a while and you are not sure about the essentials of 401k investing?
Let’s look at the brochure, the plan summary document, matching, vesting, contributions and which investments you might want to select.
How do you set up and invest in a 401k? Here is your essential guide to 401k plans!
The Glossy Brochure
Most still get a 401k brochure during on-boarding. Glance through it, but honestly there isn’t a ton of useful information. Notice the match and the vesting schedule if mentioned.
There may be information on the funds, which might look like this:
One nice thing about a 401k: your employer must limit investments to options they think are in your best interest. Figure 1 above shows a plan’s core investment options.
Note they go from conservative to aggressive. The plan brochure actually provides the comment conservative means more inflation risk and aggressive means more investment risk. Well, that’s a start. Not.
Honestly, you want to ignore graphics like figure 1. There really is no useful or actionable information here! 401k 101 lesson 1. Ignore the glossy brochure.
Otherwise, we could nit-pick several other features, but let’s just throw out the brochure after noticing the vesting schedule and the match.
Vesting Schedule and Match in your Employer’s Retirement Account
Now we are getting somewhere! You can see the vesting schedule and the match for a 401k. This is useful!
Vesting is either graded or a cliff. A cliff would be, say, 100% vested at year 3. If you leave before year three, you don’t get any of the match. Your contributions are always yours.
You can see the above vesting schedule is graded, which means the longer you work, the higher percentage of the match you get to keep.
And the match?
Matches are Free Money! Essential 401k
The match in an employer sponsored retirement plan is important! Of course, with your own contributions you get an income tax deduction.
But if your employer matches say 3%, you get an instant 100% return on your 3% investment! The Match is part of your salary, don’t leave it on the table. Make sure you are always investing enough to get matching contributions.
How much to I need to invest to get the match? You can see above there is a basic contribution that every eligible employee gets which is 1% for my plan. Some plans (especially Safe Harbor ones) are more generous with the basic match, but most plans don’t have any basic contribution.
The matching contribution in my plan is 100% of the first 5%. So, this means if I put in 5% of my salary, I get 5% match plus 1% basic = 6% match. Again, plans can have different matches. Know your 401k plan matching contributions! This is essential for 401k plans!
Also note, there is a $280k salary limitation on matching contributions. If you make $400k a year, you will only get the match on the first $280k of your salary no matter how much you contribute.
So, how much should you contribute?
How Much Should You Contribute When You Open Up a 401k?
You can contribute a percentage of your biweekly salary up to your $19.5k maximum employee contribution limit. This can either be pre-tax or Roth (if your plan has a Roth option). The employer match is always pre-tax. They want the tax write off for their matching contribution.
If you make $195k, you can contribute 10% and get your full (or “max out”) employee contribution of $19.5K.
Let’s do some quick math. Say you make $400k a year and contribute 10%. Well, that would be $40k, and you can only contribute $19.5k. So, by July you would have maxed out your 401k.
This is called front-loading. Some plans allow you to put up to $19.5k in your first pay period of the year (assuming you earn that much). Is that a good thing?
Front-loading Contributions 401k Essential
Be VERY CAREFUL Front-loading your 401k. You might not get your match!
Some plans will only match evenly throughout the year, so you have to be putting away money every pay period to get the whole match. Other plans will true you up.
What is a True-Up?
A true-up is when you plan makes sure you get all of the match that you are eligible for, even if there are monthly limits they match. So, say your company matches 6% but only will match 0.5% per month. If you max out your employee contribution at month 6, you will only get half of your match during the first six months. If your plan has a true-up, you will get the rest next year. If there is no true-up, you lose out on half of the match!
Summary Plan Description
So, to see if your 401k has a true-up or not, find the Summary Plan Description. Sometimes this can be found on line, sometimes you are going to need to ask HR for a copy.
I found my 401k plan’s Summary Plan Description on line and searched for “true.”
My plan does have a true-up. So, I can front load my plan, but I might not get my full match until next year!
Interlude: Is my 401k Any Good?
You can check the quality of your plan on-line.
Above, you can see my plan has low fees, but the match is poor.
There is below average participation in the plan, but of those who participate, salary deferral is great. This leads to average account balances.
You can also see the top three funds utilized in your 401k on a separate screen.
This is interesting and all, but unless you have a lot of energy to persuade your administration to change or improve your plan, the rating of your 401k plan is more for your own interest.
What Investments Should I make in My 401k?
So, now that you know your contribution level, match and vesting schedule, it is time to invest! This is where The Essential Guide to 401k Plans gets real!
Please note that you have to set up your contribution investments in addition to the allocation for the funds that already exist in your account. You have to change both the contribution and the existing funds if that is your intention. Just changing the contribution investment doesn’t change your overall asset allocation.
What should you invest within your 401k? On-line, you get something like this:
Ok, so do you want to look at the 1, 3, 5, or 10-year results when you make your decision what to invest in?
None of the above!
This is, perhaps, the most common mistake people make when investing in their 401k. As they say, past performance does not predict future results! Don’t even look at the past performance. Ignore this screen!
You need to decide now if you are going to use a target date fund or determine what your own asset allocation should be in your 401k.
To know what your options are, you need to know what you examine when you are picking funds in your 401k.
Pay Attention to Fees!
Remember, the best correlation to future returns are current expenses—fees. You can tab over from average annual total returns to fees and find the Expense Ratio.
Here, you can see a S&P 500 index fund has an expense ratio of 0.015% whereas TRP MID CAP GROWTH is 0.75%. Doing the math, that fund is 50 times more expensive!
Remember, fees matter! You don’t know how two funds will perform in the next day or decade, but you do know how much they are going to cost you! Fees are the only real predictor of outcomes that you can control!
How about the target date funds? How much do they cost? The Gross expense ratio is 0.74%. Ouch, that’s high! Hold on to that number for a second, because the gross expense ratio can be misleading as we will see in a moment.
Do you want a Target Date Fund or will you create your own Asset Allocation?
I used Morningstar to pull the asset allocation from the 2050 target date fund. Likely, you can find it when you click on the fund in your 401k on line platform.
Above, you can see my 2050 fund (under Net) with the category average (under Cat.).
You can see it is essentially a “three-fund” portfolio with 52.9% US, 34.5% international, and 12.4% fixed income and cash. Well, that’s not horrible.
Also, when you click on the link, you can see the “net expense ratio” is 0.37 compared to the gross expense ratio of 0.74%. This means that you are getting a discounted price on the price quoted in the prospectus.
How does 0.37% compare to national averages? Fees on target date funds are coming down year after year. I still think 0.37% is expensive, though the recent national average is closer to 0.78%.
Can we do better choosing our own funds? Let’s look at equities (stock mutual funds) and fixed income (bond mutual funds) that are available and see what it would take to create a three-fund portfolio of 60% US, 30% International, and 10% fixed income. That is 401k for dummies!
Mutual Fund Options in a 401k
Well, we already saw the equity options above. We are going to ignore past returns. We want low cost, passive index mutual funds. Most of the options are active mutual funds. While active funds have less disadvantages in tax-deferred space, we all know that passive beats active more than 85% of the time.
We know we want US, so our low-cost options are S&P 500 or a mid-cap blend (expense ratio 0.045%).
Sometimes, when you are choosing your asset allocation, you decide to “tilt” to certain factors. This tilt actually increases your risk, which should increase your returns over the long haul. Small Cap and value are common tilts. Neither are available to us. Explore the options for your 401k to see what passive index funds are available to let you decide on your US equity exposure. For me, it is 60% in the S&P 500.
You see there is a decent international fund with an expense ratio of 0.055%. This is the global ex US index. “Ex” means except, so this is the world minus the US. Let’s put 30% in there.
So far, we have 60% at 0.015 plus 30% at 0.055. What about our 10% bonds?
Fixed Income Options in your 401k
Just for fun, I included in the “income” version of the target date fund on the very top. This has 80% fixed income and is for when your target date is “now.” Next, is a very active long-short fund with an expense ratio of >1%. Ignore that.
So, the bottom three are our three fixed income options. On the very bottom if the money market account. You can see the expense ratio of 0.42% and its 1, 3, 5, and 10-year returns.
Yes, do look at returns on bonds. In fixed income, the expected return in the next 10 years are actually quite closely correlated with current yields. And, there are some reasons to use active funds in the bond world too. Bond mutual funds are complicated and a complete discussion is beyond the scope of this blog. We are looking for 10% to make our asset allocation 90/10, which bond investment would you choose?
Well, we have a total bond fund, vs an inflation protected bond fund. Since we are young a let’s go total.
Cost of Asset Allocation
So, the final 10% fixed income costs us 0.37%. Cost of our 60/30/10 is 0.0625% vs 0.37% for the target date fund.
The target date fund is almost 6x more expensive. If you have $10k invested, you will pay $6.25 or $37.00 per $10k per year.
This may not seem like a lot, but what if with a match you put in $34k a year over 20 years and earned 7% minus the above expense ratio? The difference is $45k over 20 years.
If you spend an hour a year managing your 401k (and why spend more?), you can save over $2000 a year in average costs despite even a fairly good target date fund.
Target Date Funds The Essential Guide to 401k Plans
Of course, if you have a good target date fund option in your 401k for dummies, there is nothing wrong with picking it for your new contributions and your existing balance. If this keeps you from over-managing your 401k (which you should look at no more than once or twice a year, and rebalance less than that), then you will actually likely come out ahead.
Summary: Essentials of a 401k
We have learned about vesting and employer matching. About contributions and front-loading.
To summarize how you should invest in your 401k: either pick a target date fund or decide in advance what your asset allocation is given the options you have available.
Pick low cost, passive index funds for equities. Bonds are a little trickier. But you should have bonds.
Most importantly, understand that your 401k is just one asset location in your asset allocation.
As you have multiple investing accounts, you don’t need every fund in every location. Decide which good fund options you have in your new 401k, and then fit those options into your overall asset allocation.
This is a good start at The Essential Guide to a 401k Plan.