A 401(k) isn't an actual investment - it is a type of account that holds investments. The term 401(k) comes from a section of the tax code that allows individuals to contribute money to an account for retirement, receive a tax deduction, and avoid paying taxes on any capital gains, interest income, dividends, or other profit earned on the investments in the account until the money is withdrawn, as long as specific rules are followed. Any money taken out of a 401(k) before the owner turns 59 1/2 years old is subject to an additional 10% penalty tax, although there are some ways to avoid the early withdrawal penalty and there is even something known as a 401(k) hardship withdrawal that might make it possible to access your money in the event of an emergency.
401(k) Investing Success Comes Down to a Few Important Keys
The keys to successful 401(k) investing are straight-forward and simple.
- Take advantage of any free matching money your employer might provide. This is an instant, risk-free return that can supercharge your retirement savings. For example, many companies will match your retirement contributions dollar-for-dollar on the first 3% of your salary you put into your 401(k) account. That is an instantaneous 100% return on your money, even if you park it in money market funds within the 401(k) plan.
- Continue making regular 401(k) contributions, even when the market is crashing, if you are more than a decade away from retirement because your money buys more shares of your favorite mutual funds. That can mean you are paying a lower price for future dividend income or bond interest income. Think about all of the investors that continued to fund their 401(k) account during The Great Recession when the Dow Jones Industrial Average fell from more than 14,000 to 6,000. By the time the market recovered to 12,000, every $1 they invested at the bottom had grown by 400% because they probably received $1 in matching funds, and the $2 invested doubled in value to $4 (and that isn't even factoring in the tax deduction received at the time of contribution!). Successful 401(k) investing is a marathon, not a sprint.
- Focus on the expense ratio of your mutual funds. The best option for most 401(k) investors is to own low-cost funds that invest in a broadly diversified index, such as the Dow Jones Industrial Average or the S&P 500. The reason is simple: Few investors have the skill necessary to understand how to value individual businesses or stocks. By owning low-cost index fund, you can essentially own a piece of "America, Inc." or even "Global, Inc." if you choose an international index fund.
- Have discipline and stick to your 401(k) investing plan. The biggest mistake I see is when new or panicked investors save a high percentage of their salary during bull markets only to stop contributing - or worse! - sell out of their stock mutual funds altogether during a crash! There is perhaps no quicker way to destroy any chance at a healthy retirement than to buy high and sell low.
- If you are near retirement, it is inappropriate for you to have a high percentage of your 401(k) assets invested in stocks. Although the stock market has proven to be rational in the long-run, you might not have that time horizon if you need to retire in the near future. It might be better to have a significant portion of your assets invested in bonds, money markets, or other fixed income investments.
