A 401(k) plan is an employer sponsored retirement plan that allows employees to divert a portion of their paycheck into a retirement account that offers an opportunity for growth; however it is not immune to market risk.
Some employers offer a match as well. This means they will match your contribution with their own contribution, up to a certain amount. For example, if your employer offers a 401(k) match up to 6% that means they will match whatever you put in up to 6% of your gross salary. So, at a 6% match, if you make $50,000 a year they will match up to $3,000 a year, as long as you contribute at least that much. If your employer offers a match you should take advantage of the full matching amount. If you aren't taking advantage of the match you are not receiving your full compensation from your employer.
A traditional 401(k) is tax deferred. That means your contributions are made before income tax is taken. This lowers your tax liability while you are working, but you still have to pay those taxes when you make withdrawals in retirement. This may be a good thing because your tax bracket could be lower once you stop working.
Your employer may offer a Roth 401(k). This is similar to a traditional 401(k) however you pay the taxes on your contributions while you are still working in order to make withdrawals tax free later on. To learn more about this see my blog titled Traditional 401(k) vs Roth 401(k). 401(k) Investment Options
There are a number of investment options that you may have in your 401(k) plan. There are mutual funds, exchange traded funds (ETFs), index funds, along with bond funds. Some will be actively managed while others are passively managed. There is a good chance you will see some, if not all, of the below.
Large Cap Funds
These are funds made up of stocks from big companies with large market capitalization; often companies that you have heard of, or are mentioned often in the news. These are established companies with a track record of slowly but surely making their shareholders money over a long period of time. This may be a good option if you are looking for a long term investment with lower risk.
Small Cap Funds
These are funds made up of stocks from small companies. They typically have the greatest potential for growth since these companies are trying to expand aggressively. However, they are more vulnerable to economic downturn making them more volatile. If you are not adverse to a high level of risk, and want the possibility of strong growth, this may be for you.
Mid Cap Funds
These are funds made up of stocks from mid sized companies. So this is the middle of the road. Not as volatile as small cap funds but has better growth opportunity than large cap funds.
Just like the name implies, these are funds that are made up of stocks from companies that are outside of the United States. Funds can include stocks from companies from developed or emerging markets. It could be one or the other, or both.
This is another type of mutual fund but it is made up entirely of bonds. They could be corporate bonds, government bonds, short term, or long term bonds. Bond funds are popular because the market risk is typically lower than funds comprised of company stock. However, even though they typically are a "safer" investment option in your 401(k) they are not risk free.
Target Date Funds
Typically, when evaluating risk tolerance, the younger someone is the more risk they are willing to take with their investments because they have more time to recover from down markets. So as you get older, and closer to retirement, your asset allocation should change from stock based investments over to bond based investments. With a target date fund that asset reallocation is done for you over time. Basically you choose the fund for the year you are planning to retire. So if you are 30 years old today, and want to retire when you are 65, you should choose the fund for the year 2054. Asset allocations change automatically as you get closer to that date. You take on more risk when you are younger and less risk the closer you are to retirement.
You may also see some index funds in your 401(k). These are passively managed funds tied to an index, like the S&P 500 for example. Index fund managers choose securities that mirror the particular index the fund tracks, rather than active management, where fund managers buy and sell securities based on market timing. With index funds, the makeup of the portfolio changes when the benchmark index changes. Index funds offer investors diversity, low costs, and long-term returns. But they are also susceptible to changes in the market and aren't very flexible.
A 401(k) plan is an employer sponsored retirement plan that allows you to allocate part of your salary to the plan.
Your contributions could be tax free while you are working.
There may be an employer match that really boosts your retirement savings.
401(k) assets should be reallocated over time to make sure it stays in line with your risk tolerance.
There is always risk that you could lose money. You should speak to a financial professional.
Have questions about your 401(k) or other retirement plan? Let’s talk about it. Contact me today at 866.QUEST.01 (866.783.7801).
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