Using Your 401(k) to Invest
You’re fortunate that your 401(k) is offered through the investment company Vanguard. That’s because Vanguard has some very low-cost investments. That’s good news for you, the investor. Unfortunately, Even Vanguard’s 401(k) can list some high-cost products on their investment menu. Picking the low-cost funds off of the investment menu – those with the name “Vanguard” – means paying less money to investment managers. Avoiding the higher cost funds – such as those with the names “T. Rowe Price” and “Dreyfus” can mean keeping more money in your account.
Which Vanguard Funds Do I Pick?
If you’re not a giant investing nerd like yours truly, Vanguard’s 401(k) has a very simple solution for you: the Vanguard Target Date Fund.
A target retirement date fund is different from most other investment funds. Most funds are usually made up of just one type of investment – like United States bonds, or European stocks. A target date fund is a single fund composed of many different types of investments. Moreover, the investments in a target date retirement fund change over time: buying less stocks (relatively risky), and buying more bonds (relatively safer than stocks) as you move closer to retirement. This change in investment holdings happens automatically – without any additional work from you, the investor.
The fund also rebalances automatically – selling those investments that have increased relative to those that have decreased. This automatic rebalancing keeps your investments on point without any effort on your end. By using a target date fund, you get full diversification, automatic rebalancing, and your investments are synced to your timeline for retirement. It’s pretty much the best thing to happen to the retail investor.
Target date funds are usually available in five-year increments; target date 2015, target date 2020, target date 2025, etc. If you do opt for a target date fund, consider the particular target date fund that is closest to the particular year you plan to retire.
Finding the Right Tool for You
Of course, you do not have to use the target date fund. For those do-it-yourself investors who enjoy picking their own investments, it may not make sense to hold a target date fund and other plain vanilla funds. However, if you decide to pick your own investment funds, remember to periodically review those funds. Over time, you will not only need to decrease your stock fund holdings relative to your bond holdings (i.e. adjusting your investments to reflect your timeline to withdrawal), but you should purchase those funds that have decreased in value relative to those that increased in value. This latter process is called rebalancing and is customarily done annually.
Our Family Investment Portfolio in Vanguard’s 401(k)
I’m a nerd. I really, really enjoy creating investment portfolios to help people reach their goals. I get equally giddy about creating my own portfolio as I do about those for clients. So, here’s how I invest my family’s money in our 401(k) at Vanguard…
Just kidding. I’m not going to show you that just yet. First, I want to preface me sharing my own portfolio in Vanguard’s 401(k) with the understanding that is our family’s portfolio – just for us. This portfolio works for us because it is in alignment with us portfolio goals: growth over a very, long timeline. I know that we won’t be touching the money in the 401(k) for a solid 30 years – and likely longer than that. I also know that we’re comfortable with losing money in the short-term. And by the short-term, I mean 15 years. If I see the portfolio – or just part of it – underperforming, that’s OK with us. In fact, that’ll just incentive us to buy more of whatever has decreased in value. So, given our goals and risk tolerance, the following portfolio works for us- and it may – or may not – work for you if you’re a do it yourself-er:
- Vanguard Total Stock Market Index Fund Institutional Plus Shares 20%
- Vanguard Small-Cap Value Index Fund Institutional Shares 20%
- Vanguard Developed Markets Index Fund Institutional Shares 11%
- Vanguard FTSE All-World ex-US Small-Cap Index Fund Institutional Shares 11%
- Vanguard Emerging Markets Stock Index Fund Institutional Shares 16%
- Vanguard REIT Index Fund Institutional Shares 22%
401(k) EMPLOYER MATCH
Can I interest you in some free money? Then look no further than your employers match on your 401(k) contributions!
As you may know, your 401(k) isn’t the only way to invest for retirement. For example, you can always save money in an Individual Retirement Account (IRA).
So, should you be using your company’s 401(k) to invest?
Yes! (Did I mention the free money?)
The point of a match on 401(k) contributions is to get employees (i.e. you) to put money into your retirement plan – the 401(k). And offering matching contributions is a pretty good incentive – because taking advantage of your employer’s offer to match a part of your 401(k) contributions gives you a little pay raise.
The Numbers on the Match: A Not-So-Hypothetical Example
Not all employers offer a match on 401(k) contributions. And the amount matches vary by employer. To illustrate, I’ll use an example of match that widely used in the accounting industry.
For every dollar you put into your 401(k), your employer will throw in 25 cents. Your company makes this offer for up to 6% of your salary.
You do not need to be an accountant (or a financial planner) to know that your 401(k) match from your employer makes saving for retirement a good deal. In other words, who wouldn’t want a:
FREE 1.5% PAY RAISE?
If a 1.5% pay raise doesn’t sound like a good deal, let’s look at this match from another perspective: the investment return on a 401(k) match.
The Best Investment Return You Can Get
To put investment returns into perspective, consider:
Investing in stocks has historically averaged a 10% return per year.
So, were you to invest, you might expect a 10% return after one year. And that’s not bad.
Now think about what taking advantage of the 401(k) match does for your investment return: you get an additional 25% investment return in the first year!
10% + 25% = 35%
Let’s use a hypothetical example to see how all of this works:
Joe Danger is a first-year at a big accounting firm. Joe makes $50,000 a year. He contributes 3% of his salary to his 401(k), or $1,500. His employer adds $375 to Joe’s 401(k) account.
As a second year, Joe gets a raise, bumping his salary up to $55,000. He now decides he’s going to take full advantage of the 401(k), by contributing 6% of his salary, or $3,300. His employer puts in $825.
By putting in $3,300, Joe gets $4,125. Nice!
The Limits on the Match
Unfortunately, there is only so much of a good thing to go around: the big accounting firm only matches 25% on the first 6% of your salary. So, were you to put in more than 6%, the company would only contribute based on the first 6%. Here’s an example:
As a senior, Joe now makes $65,000. He decides to contribute the entirety of his new raise to his 401(k), for a total personal 401(k) contribution of $13,300.
The accounting firm puts in only $975, because the 25% match is capped at the first 6% of contributions.
Matching with a Roth 401(k)
The above example assumes Joe utilizes a traditional 401(k). If Joe opts for a Roth 401(k) – because he understands the tax benefit of doing so – his post-tax contributions will be matched with pre-tax dollars. The matching pre-tax dollars are treated as a traditional 401(k):
- the employee is not subject to tax for the matching dollars when the dollars go into the 401(k) account
- while the money is still inside the account, there is no tax on any growth of the investment
- the employee will pay taxes when money comes out of the 401(k)
The investment companies that run the retirement plans for the Big Four (Vanguard, as one example) have the tools to make distinguishing the balance of the post-tax Roth account employee contributions from the pre-tax matching contributions relatively easy. You may be able to see how much of each type of investment you have on your quarterly statement.
Should I Contribute More than 6% to My 401(k)?
Probably. But the answer really depends on your goals. I’ll use my family as an example.
Example number 1 – My brother:
My brother works for a company that has a fantastic 401(k). (Why is it fantastic? Because it has low-cost investments.)
My brother is shoveling money into his company’s 401(k), because it’s a great, low-cost way to save for retirement. And that works for him because my brother’s primary goal is saving for retirement.
Example number 2 – my wife (an employee in the accounting industry):
She’s currently putting in the 6% into her 401(k) – because we’re not fools; we’ll take the free money (from the match).
But, after that 6%, we’re saving most of our money outside of the 401(k) – saving it for a down payment on a property. So, for us, we’ll put away 6% – and devote the rest of our income towards goals other than retirement.
GET THAT MATCH!
Beg, borrow or steal – but do you whatever you have to do to get the match! It is free money!
YOUR 401(K) ACTION PLAN
- Sign up to contribute at least 6% to your Roth 401(k)
- Pick the Vanguard Target Retirement Fund that’s closest to your retirement year
Disclaimer: Any views or opinions presented in this article are solely those of the author and do not necessarily represent those of anyone. The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell any investments ever under any circumstances, most especially those investments mentioned, or to solicit transactions or clients. Past performance of the investments discussed will most likely not continue and the investments will likely not achieve the returns as implied. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for their specific situation.