401(k) investing is the cornerstone of many workers' retirement plans. You sign up, choose how much you're going to save from each paycheck and pick a few mutual funds. Then most people do nothing--sometimes for years. That's not good enough.
You've taken the correct first steps, but your job isn't done. It's essential that you give your 401(k) regular checkups. Here are three steps to a healthy and happy 401(k).
Step 1: Check Your Investments I bet you spent more time researching your new plasma television or cell phone than you did your 401(k) investments.
When you first signed up for your 401(k), you probably made your selections based, at least in part, on how specific funds performed. As time has passed, your mutual funds have changed. Maybe the ones you picked are still top-notch--or maybe they've taken a plunge. Perhaps there's a new fund manager.
You don't have to be a professional money manager to check on the health and performance of your investments. Go to morningstar.com, a site that tracks mutual fund performance. Enter the names of your funds in the search area, and you'll be directed to a screen that's filled with data about each fund. Don't let the big line graph and all those numbers intimidate you. You don't need to translate it all.
Scroll down beneath the graph and peruse the box marked "Performance." This will tell you in percentage terms how much your fund is up--or down--over different time periods, including year-to-date (YTD on the chart), one month, one year, three years, five years and 10 years. Focus on the one-year number to see how your fund has done over the past 12 months.
Next, compare that number to the third line of data (+/- category), which shows how the fund performed compared to funds from other companies that invest in the same area. This comparison is just as essential as the actual performance number because it will show you if your fund has performed better or worse than its peers. You might be happy if your fund is up 5 percent, but if you then see that similar funds gained 15 percent during the same time period, you'll realize your fund may be lacking.
If your fund has consistently beat others in its class, great. If it hasn't, it's time to reevaluate the investment. Let's say your plan only offers one small-cap stock fund, and yours has underperformed compared to others in the same category for an extended period of time. You can't force your employer to offer a different fund, but you can remove the small-cap fund from your 401(k)--and you might purchase one elsewhere, such as in your IRA, instead of investing in a sub-par fund. Just make sure your overall asset allocation is right.
Step 2: Reallocate
One of the advantages of a 401(k) plan is that you can put your retirement savings on auto-pilot. Your contributions are taken out of each paycheck throughout the year. But you need to make course corrections periodically based on factors such as changing market conditions and your own changing financial needs as you grow older.
Each 401(k) plan offers different investment choices. When you first signed up for the plan, you created an asset allocation (the split of your money into different investment types) to fit your goals, your stomach for risk and your time horizon.
You, and only you, can make sure that well-thought-out asset allocation continues as intended. Each of your investment choices is a moving part, and it's your job to check those parts and make sure the brakes are in working order.
Let's say, hypothetically, that you have $100,000 in your 401(k), evenly divided between a U.S. stock fund and an international fund. (That's certainly not a diverse portfolio, but let's make it simple to illustrate my point.) That's $50,000 in each fund. Over the next six months, imagine your U.S. stock fund gains 10 percent and your international fund loses 10 percent. You'd now have $55,000 in the U.S. stock fund and $45,000 in the international fund. Your portfolio will be out of balance and no longer consistent with the asset allocation you originally selected. It's time to readjust.
At least once a year--or better yet, every six months--reallocate the funds in your 401(k) to make sure you still have the correct percentage in stocks, bonds and cash. Keep in mind that your 401(k) is only a piece of your portfolio. If you have other investments, you should consider your overall asset allocation before moving money within your 401(k).
As you get older, you may want to make changes even if your original asset allocation is standing firm.
When you're further away from retirement, it's smart to have more of your money in stock investments. If there's a market downturn (like we're experiencing now) you have plenty of time for those stock investments to recover.
As you near retirement--and come closer to withdrawing your savings to support your lifestyle--you can't afford to risk as much money in stocks. Financial advisors recommend you increase your bond and cash accounts to protect your savings from potential market downswings. Don't make the mistake of eliminating stocks from your portfolio completely. To keep up with inflation, which will erode your purchasing power over time as prices rise, you need growth in a portion of your portfolio. That means some exposure to stocks, but not as much as when you were younger.
While you're looking at your 401(k), check to see if your employer has added any new investment selections to the plan and consider those options, too. Also make sure that no more than 10 percent of your 401(k) is invested in your employer's stock. You rely on this company for your income. You don't want to bet your entire retirement on it, too--as employees of Enron, Lehman Bros. and others learned the hard way.
Step 3: Revisit Savings Rates
401(k) contribution limits change, so make sure you stay current.
If you started contributing to your 401(k) in 2005, you were allowed to contribute a maximum of $14,000 a year. That maximum is higher now, but unless you notified your employer each year that you wanted to increase your contributions, you're still contributing at 2005 levels.
The maximum contribution limit in 2010 is $16,500. That amount will rise in $500 annual increments based on cost-of-living increases, as determined by the government. If you're 50 or older, you may contribute an extra $5,500 in 2010 as a "catch-up" contribution.
How much should you save? A few tips:
- Each dollar you save in a 401(k) lowers your taxable income.
- Your savings will grow tax-deferred, meaning you won't owe any tax until you withdraw the funds.
- If you can save the max, do it. If you can't, at least save enough to take full advantage of your employer's matching funds.
- If you're not saving the max, increase your contributions by $1,000 a year (that's only $83 a month), and you'll barely notice the difference in your paycheck.
- If you receive a raise, increase contributions to your 401(k). You won't even miss the money.