How to Pick Investments in Your 401k

Your retirement will depend on how well you manage your 401k plan. By managing it properly, you can grow your 401k to help insure it will support the retirement you're dreaming of.

The most important aspect of managing your 401k well is to contribute the optimum amount.

If your company offers matching contributions, contribute at least enough to receive the full company match. Otherwise, you're throwing away free money. Many companies give their employees 50 cents for each dollar they contribute, up to 6% of salary.

If you can afford to save more for retirement after contributing enough to your 401k to receive the full match, fund an Individual Retirement Account. In 2013, individuals can contribute up to $5,500 in an IRA, plus a "catch-up" contribution of up to $1,000 if age 50 or older. Fund a Roth IRA if you expect your tax rate to rise after retirement; otherwise fund a traditional IRA.

If you can afford to save still more for retirement after maxing out your IRA, contribute more to your 401k until you reach the contribution limit of $17,500 (for 2013). You won't get a company match, but your contributions and any returns on them will grow more quickly since they'll be tax deferred.

If you think you can't afford to contribute to your 401k, start with a small contribution even if its as little as 1% of your salary. Then increase your contribution with each raise. Or, allow your company to automatically increase your contribution by 1% each year if they offer that option.

If terms like "asset allocation", "expense ratio" or "investment risk" give you brain freeze, your best option may be to invest all of your 401k contributions into a target-date fund, which are offered by most 401k plans. Simply pick a target date matching the year of your expected retirement, and direct 100% of your contributions into that fund. A professional money manager will then manage your 401k account in a manner appropriate for a person of your age. Refrain from directing some of your contributions into other funds since that will limit the target-date fund's effectiveness.

Target-date funds aren't for everyone, since they often charge one percentage point more in fees than other funds, and since their investment objectives may not match those of certain individuals.

If you prefer to select your own 401k investments, follow this five-step process:

1. Review the investment funds offered by your 401k plan to see what's available. Understand what asset class is covered by each fund. The major asset classes are: large-cap stocks; mid-cap stocks; small-cap stocks; international stocks; bonds; inflation-protected securities. Your 401k plan may also offer a stable-value fund with a fixed and guaranteed return.
2. Select your desired asset allocation. Your asset allocation defines how you want to allocate your 401k investments among different asset classes. You'll want an asset allocation which diversifies your investments to decrease your risk without impacting long-term returns. An example of a well-diversified allocation is as follows: 20% in a large-cap stock fund; 15% in a mid-cap stock fund; 15% in a small-cap stock fund; 20% in an international stock fund; 15% in an aggregate bond fund; and 15% in a treasury-inflation protected (TIP) bond fund.
3. Identify the specific investment options offered by your 401k plan which align with each of the asset classes in your desired asset allocation. For example, if your desired asset allocation includes 20% in a large-cap stock fund, identify all of the large-cap stock funds in your 401k plan. Many 401k plans offer multiple investment options for each of the major asset classes.
4. Select the best investment option for each asset class in your desired asset allocation. To select the best options, review each fund's fees and expenses, and long-term performance history (e.g., over the past 5 or 10 years). For example, if your 401k plan offers two large-cap stock funds which have performed about the same over the past 5 years, but the first fund has annual fees of 0.5% and the second fund has annual fees of 1.0%, pick the first fund. In most cases, you will be better off selecting an index fund rather than an actively-managed fund, since the fees will be lower and the long-term performance better.
5. Once you've selected your desired asset allocation and the best investment option for each asset class, instruct your 401k provider to invest your contributions accordingly. Many 401k providers give their customers simple forms to input these instructions, either online or offline.

If you have other investments outside of your 401k plan, you should coordinate your 401k investments with those other investments.

For example, assume your desired asset allocation includes 60% stocks and 40% bonds. If you own $50,000 in stocks in a taxable account outside of your 401k, and your 401k balance is $50,000, you would want your 401k to contain $40,000 in bonds and only $10,000 in stocks.

In coordinating your 401k with other investments, you should consider the tax implications. In the previous example, keeping the $40,000 in bonds in your 401k would have the advantage of deferring taxes on the bonds' interest payments, while keeping the $50,000 in stocks in a taxable account would allow you to take advantage of today's relatively low tax rate on stock distributions.

Periodically rebalance your 401k investments to insure they maintain your desired asset allocation. For example, if you selected an allocation of 60% stocks and 40% bonds, but changes in investment returns have changed your allocation to 70% stocks and 30% bonds, sell stocks worth 10% of your account and use the proceeds to buy more bonds to return to your desired allocation.

It'll usually be sufficient to rebalance your 401k account once each year. If your 401k provider offers automatic rebalancing, you can easily rebalance more frequently. With automatic rebalancing, the account holder specifies a desired allocation between the investment offerings and the rebalancing interval, and the account is automatic rebalanced per those instructions.

Avoid taking any actions which will damage or destroy your 401k.

Absent a life-or-death situation, do not borrow money from your 401k. Many companies allow you to borrow the lesser of $50,000 or one-half your balance, and may make taking a loan sound painless since you pay back the loan and interest to yourself. These loans are bad since you lose potential investment gains on the borrowed money, you'll pay more in taxes since you repay the loan with after-tax dollars, and you must repay the loan in full within 60 days if you leave the company.

Don't cash out your 401k if you leave the job. If you do, you'll owe income tax on the full amount, plus a 10% penalty. You'll also suffer a substantial setback in saving for retirement. Instead, roll the money into your new employer's 401k plan or into an IRA.

Don't react to the financial markets. Resist any temptation to cash out whenever the stock market is turbulent. Instead, stick to your desired asset allocation.