Your 401(k) plan's ultimate size is primarily a function of two factors - how much you contribute and how much you earn. Of course, you know you should contribute the maximum amount possible ($17,500 in 2014). But what steps should you take to maximize your returns? Consider these tips:
- Take advantage of employer matching contributions.
Contribute at least enough to take full advantage of any matching contributions. You simply lose the money if you don't use it. A 50% match on your contributions is like boosting your return by 50% in the first year. If you plan to contribute the maximum and your employer matches contributions, have the $17,500 taken out of your pay uniformly throughout the year. Most employers match your contributions as they are made, so you could forego some matching funds if you reach the limit before year-end. For instance, assume you earn $150,000, your employer matches 50 cents per dollar on up to 6% of your pay, and you contribute 14% of your pay. After two-thirds of the year, when you have earned $100,000, you will contribute the maximum of $17,500, and your employer will have contributed $3,000. If you contribute 9.33% of your pay instead, your contributions will be spread throughout the year and your employer will contribute $4,500, an additional $1,500 match.
- Select your investment alternatives carefully.
Since you are responsible for investment decisions, understand all alternatives and review all available information before making choices. Keep in mind the long-term nature of your retirement goal and select investments appropriate for that time period. For most participants, that will mean that a significant portion of their portfolio should be invested in growth alternatives, such as stocks.
- Rebalance periodically.
Numerous studies have found that rebalancing reduces portfolio volatility, often with increased returns. By rebalancing, you are following a fundamental investment principle - you are buying low (those investments that are underperforming) and selling high (those investments that are performing well). Keep in mind that you set your asset allocation strategy because you believed those were the appropriate percentages of various investments that you should own. Thus, you need to make rebalancing a habit so your portfolio doesn't become more risky than intended.
- Limit the amount of company stock owned.
Purchasing too much company stock is risky. Not only is your job and livelihood tied to the company, but your retirement savings are also tied to the same company. It is generally recommended that any one stock not comprise more than 5% to 10% of your portfolio's value. If you own company stock in your 401(k) plan, look at how much of your total balance it represents. Take steps to immediately reduce that percentage if it is over 10% of your total portfolio.
- Don't borrow from your 401(k) plan.
While it may be comforting to know you can gain access to your 401(k) funds when needed, only borrow as a last resort. It's true that you are borrowing from yourself and will pay interest to yourself, but there are also hidden costs to this borrowing. When you borrow, some of your investments are sold. While your loan is outstanding, you miss out on any capital gains or other income those investments would have earned. Interest rates are typically very reasonable with 401(k) loans, often prime rate or a couple of points over prime. That makes it easier to pay back the funds, but could mean your 401(k) account is earning lower returns than if it was invested in other alternatives. Also, if you leave the company while a loan is outstanding, you must repay the entire balance within a short period of time or the loan will be considered a distribution, subject to income taxes and the 10% early withdrawal penalty if you are under age 59 1/2 (55 if you are retiring).