401(k)s provide a simple way to save for retirement as well as some attractive tax perks. Whether you already have one or are opting into one for the first time, you might be wondering how to invest your 401(k). Your investment options will depend largely on your plan administrator.
Once you're clear on how it works, you can use your 401(k) to supercharge your nest egg.
1. Understand How 401(k)s Work
A 401(k) is an employer-sponsored account designed specifically for retirement savings. According to the Society for Human Resource Management, 94% of employers offered a traditional 401(k) in 2022. Here are some important characteristics of a 401(k):
- The money you put in will reduce your taxable income. Contributions to your 401(k) are made on a pretax basis, which reduces your taxable income while you're still working.
- You'll enjoy tax-deferred growth. You won't pay taxes until you begin making withdrawals.
- There are contribution limits. Contributions are typically made through automatic payroll deductions. In 2023, you can kick in up to $22,500. Folks who are 50 and older can contribute an extra $7,500.
- Early withdrawal penalties may apply. Cracking open your 401(k) before age 59½ usually results in a 10% penalty.
- You have to start taking distributions once you turn 73. That's when required minimum distributions (RMDs) kick in.
- Your employer may match some or all of your contributions. An employer match is a nice benefit that can help accelerate your retirement savings.
2. Know Your Risk Tolerance
Your personal risk tolerance will affect how you invest your 401(k). The main goal is to sell securities for more than you paid for them—and realize gains after covering your tax liability. But returns are never guaranteed, and some investments are more volatile than others.
Stocks are considered high-risk investments because the market is constantly in flux. Stock values can surge or drop with little notice. But investors who stick with it could position themselves for long-term growth. The stock market has had an average annual return of about 10% over the past century—and has historically recovered from previous downturns. If you're more risk-averse, holding 60% stocks and 40% bonds is seen as a moderately conservative asset allocation.
As a general rule, it's wise to dial down the risk as you get closer to retirement because you have less time to bounce back from market volatility. No matter your age, staying diversified can help mitigate investment risk and offset potential losses. This means investing in a variety of holdings and asset classes.
3. Decide How Much to Invest
There isn't a magic formula for deciding how much to save for retirement, but the following factors can help you clarify your target:
- Your age: The longer your money is invested, the more time you have to benefit from compound interest. One rule of thumb to better ensure you're prepared for retirement is to invest 15% of your income during your 20s and 30s, then 20% in your 40s and beyond.
- Your financial situation: If you're in the process of paying down high-interest debt, it's possible to save for retirement at the same time. For example, you might contribute just enough to secure an employer match, then use excess funds to accelerate your debt payments.
- Your retirement goals: It may be a long way off, but think about the type of retirement you want to have. Frequent luxury travel, for example, may necessitate a larger nest egg. One common benchmark is to save 75% of your preretirement income before you stop working. Your actual target will depend on your retirement goals and expenses.
- Other retirement income sources: That can include Social Security, pensions, annuities, and permanent life insurance. A financial advisor can help you work these details into your retirement plan.
4. Pick 401(k) Investments
Understand Your Options
The employer and 401(k) provider typically decide which investment options are on the table. If they're more limited than you'd like, you can always expand your investments with other accounts. With an individual retirement account (IRA) or brokerage account, you can trade individual stocks and bonds, among other assets.
Select the Right Investments for You
Within a 401(k), you can expect a mix of:
These investment funds can hold multiple securities, providing automatic diversification. Plan participants can research their options and choose funds that are aligned with their risk tolerance. Some 401(k)s also offer a self-directed brokerage account. This allows employees to invest in a wider range of securities that go beyond the plan's default selections.
If that sounds intimidating, you may be able to opt for a target-date fund. That will invest your 401(k) in a way that's appropriate for your age. Target-date funds get more conservative as you approach retirement, which means a 25-year-old's investment portfolio will look different when compared to that of someone in their 50s.
5. Make Changes as Needed
Despite your best intentions, your investment plan might change. Below are a few situations that may require you to revisit things:
- You change jobs. If you leave your current employer, you might roll your old 401(k) into a new one at your next employer. Alternatively, you can convert it to an IRA and continue saving.
- Your income needs change. You might face a temporary setback that stretches your monthly budget, like a medical emergency or loss of income. In this situation, you may be forced to reduce your 401(k) contributions.
- You make early withdrawals from your 401(k). On top of a potential early withdrawal penalty, withdrawing 401(k) funds ahead of retirement could cut you off from future investment returns. If you go this route, you may want to make larger contributions going forward or make catch-up contributions.
The Bottom Line
There isn't one right or wrong way to invest your 401(k). Your risk tolerance, investment options and financial situation are all important factors to consider. When in doubt, a financial advisor can provide personalized guidance and recommendations. What matters most is routinely saving for retirement—and taking advantage of an employer match if one is available.
Whether you're coming up on retirement or still have decades ahead, Experian can help you manage your credit health. Our free credit monitoring tool is a simple way to keep an eye out for changes in your credit report and credit score.