Skip to Content
Commentary

How to Invest In Your 401(k)

Starting a new job? Here's a beginner's manual to understanding 401(k)s.

Editor's note: This article originally ran on Jul. 24, 2020.

This month marks a significant milestone for my family as my oldest child, who graduated from college in May, begins his first full-time job, which gives him access to a 401(k) for the very first time.

Given the work my team at Morningstar does providing advice on 401(k) lineups, along with the many years I've spent researching and working on retirement products, I felt I was well-placed to offer my son a few tips on how to best invest in his own 401(k). I hope these guidelines will be valuable to others starting their careers or looking for a refresher.

Note that while I reference 401(k)s throughout this article, my comments are generally applicable to workers whose employers offer 403(b) or 457 plans instead, which are intended for nonprofit, governmental, and educational institutions.

Here are some insights into how 401(k)s work and my top suggestions for getting the most out of yours:

What a 401(k) Is, and What It's Not
Although the 401(k) plan wasn't originally designed to be the primary retirement vehicle for U.S. workers, the decline of pension plans since the early 1980s has forced plans like 401(k)s to occupy that role. The key consequence for most new workers is that the heaviest burden of saving for retirement now rests largely on their shoulders.

A 401(k) aids in that process by granting you a tax benefit: first by allowing you to defer a portion of your salary before taxes, and second by allowing those savings to compound tax-free. Down the road you will then pay income taxes on the distributions you take. If it's made available by your employer, the newer Roth 401(k) flips that around by taking away that up-front tax benefit but allowing you to take the distributions tax-free later on.

Taking the First Step
To borrow from the immortal catchphrase of Star Trek's USS Enterprise Captain Jean-Luc Picard, your first and most important step with respect to a 401(k) is simply to "engage" with it by signing up for the plan. When it comes to sending a percentage of your paycheck to your 401(k) account, my message is to start with whatever you can afford, even if it's a small percentage--ideally up to the level of your company match.

There are several benefits in doing so. One is simply to develop the habit of investing early in your career, which can become second nature and be built upon as your cash flow increases. Another is the power of compounding interest. Although the dollar amounts trickling into your account early on may seem depressingly small, you can look at any number of models to see how the steady accumulation of even small amounts over very long periods of time reaps great rewards.

In the past, we've demonstrated how you could attain a $1 million account balance at age 65 by contributing just a shade over $5,000 per year (including employer matches), if you started at age 22. Delaying your first investment until age 30 would drive up that required annual amount to nearly $9,000. So, it's in your best interest to start early.

Learn to Juggle
Many young people are struggling to balance multiple financial goals, including regular expenses, multiple forms of debt payments, and the need to build up an emergency fund. Experts have differing views on how to prioritize managing expenses and debt. My own view is that, to the extent possible, you should try to tackle multiple goals at once.

As noted above, if you can start out with making even small contributions to your 401(k), you'll be giving yourself a huge head start. And this sort of financial juggling is something you'll have to do throughout your life. Later on, it may involve saving for an automobile, a house, or a child's tuition, so take advantage of only having to worry about a few things now and establish good habits.

If you happen to be working remotely from your parents' house right now while saving on rent, travel, and eating out, there's no time like the present to use that extra income to build up your emergency fund and stash more in your 401(k).

Raise the Stakes
You may be wondering how much you should invest in your 401(k). It goes without saying, of course, that the more you can invest, the better.

Once you've established that regular contribution habit, there are relatively painless ways to increase your contribution rate over time. One is to sign up for an "auto-escalation" feature that many plan providers offer, allowing you to automatically raise your contribution rate by a preset amount on a regular schedule--say by 1% or 2% each year.

Another option is to commit to lifting your contribution rate by the amount of your raise each year, which will have no effect on your take-home pay. A more advanced move is to devote a higher share of any bonuses you receive to your 401(k), which will help plump up your account value.

Mind the Match
Another way to compound the effects of your 401(k) contributions is to take advantage of any employer-matching program that might be available. Matches are typically constructed to mirror a certain percentage of your own contributions, up to a given level. For instance, an employer might contribute 50 cents on the dollar up to a 6% deferral rate.

In that scenario, let's say you earn a salary of $60,000 per year. If you elect to contribute at the 6% level, that means you'll put in $3,600 of your own money during the year, plus your employer would contribute an additional $1,800. (Keep in mind that you'll also be reducing your taxes because the pretax contributions will lower the income level that you declare to the IRS.)

Two things should be called out here, though. First, there is occasionally a brief waiting period of a few weeks before an employee is eligible to participate in these kinds of plans. Second, while your employer may contribute to your 401(k), there will likely also be something called a vesting schedule in place that determines when you gain full ownership of employer contributions. In many cases you won't have access to 100% of your employer's contributions for a couple of years. (Your own contributions are always yours, even if you switch jobs.) Since this is "free money"--or, more accurately, additional compensation from your employer--most advisors recommend contributing at least up to the level of the employer match to get the biggest possible benefit.

5 Ways to Keep Investments Simple
We've all heard stories about young people opening up Robinhood accounts and day-trading stocks to their hearts' content. Let me categorically say that your 401(k) is not the place to take unnecessary risks or get overly complicated. As I've written in the past, a simple approach to choosing 401(k) investments is often the best.

Here are five methods you can use to do just that:

1) Consider Target-Date Funds
These funds offer a convenient way to invest money that will grow over time and shift your investments from riskier stocks with potentially higher returns to more secure bonds as you get closer to retirement. It's best for you to pick a vintage year closest to when you'll turn 65.

2) Consider Index (Passive) Funds
These funds track an entire market (the S&P 500, for example) at once. Consider selecting a broad equity index fund or combining a U.S. and international index to have a wider variety of assets working in your favor.

3) Avoid Trendy Areas of the Market
Don't choose to invest in a fund just because it's had great recent returns, as research shows that markets tend to be heavily mean-reverting. Remember, in retirement, you're playing the long game.

4) View Active Funds With Caution 
Be wary of actively managed mutual funds, which may have higher fees, more erratic performance, and generally require more attention on your part.

5) Stick With Your Plan's Options 
If your plan offers a brokerage window where you can access stocks, exchange-traded funds, and funds not available through your plan, it's best to pretend it doesn't exist.

Lock It Up and Throw Away the Key
I'm exaggerating for the sake of effect here, but I often think that one of the most helpful steps investors can take is to simply forget the passwords to their accounts, depriving them of the ability to constantly check their balances.

If you've made smart, strategic choices up front, and you have the benefit of a time horizon of 30 to 40 years, there's really no reason to check in on your account on anything more frequent than an annual basis. The quarterly ups and downs of the stock market are irrelevant to your long-term returns, and checking in during a bear market may induce you to panic and make poor, emotionally driven decisions.

During that annual check-in, you should make sure that none of your holdings have performed significantly out of line with your expectations. If you've gone the route of selecting a target-date or index fund, you likely won't have much to do in the way of reallocating. But if you have selected multiple funds from multiple asset classes, you should rebalance if weightings have diverged significantly from your targets. It's also a good time to consider raising your contribution rate if you haven't signed up for an auto-escalation feature.

Note that there are ways to gain access to your 401(k) funds prior to retirement, but doing so is generally not recommended. "Hardship" withdrawals are allowable if you meet certain criteria defined by the IRS, but you will be subject to taxes and penalties.

You can also take a loan from your 401(k), which you then repay through additional contributions to your account at a predetermined (usually variable) interest rate. Just know that depleting your 401(k) assets can do serious damage to your long-term investment plan, so you should only consider it under extreme circumstances. (Here's a more detailed list providing 20 common mistakes that investors make with their 401(k)s).

Don't Let Your 401(k) Stress You Out
First jobs are a time of anticipation, excitement, and exploration. Take the time to make the most of your work experience and don't let your 401(k) become a source of stress. Get the big picture right with a low-key approach like I've described above, then devote your energy to building your career skills. In the end, your human capital will drive your earnings growth, and therefore your retirement savings, more than any other action you can take in your 20s.