How To Make Better Use Of Your 401(k) Even If Your Investment Choices Are Limited

As you think about retirement, a 401(k), if your employer provides one, can be a good way to achieve financial security when you get there.

Employer matching together with the rapid growth of self-directed brokerage options can make a 401(k) can effective way to save.

The benefits of a 401(k)

A 401(k) can be a great way to save for retirement. It's named after the part of the tax code that enabled it. A typical 401(k) is tax-deferred so you typically don't pay tax on the money that you contribute to it, when you put it in, and the money can grow tax-free.

Remember, you employer normally deducts tax from your salary before you receive it, but with 401(k) contributions that doesn't happen.

Depending on your income level, if you make large 401(k) contributions, then it could even nudge you into a lower tax-bracket.

Of course, the downsides from a 401(k) are that you are expected to use the money for retirement and may pay penalties if you don't. Also, in retirement, you'll likely end up paying tax on the money you take out of your 401(k). Not all employers offer 401(k)s and some offer similar but not identical plans such as 4013(b)s.

However, even in retirement, you may come out ahead, based on the length of time your money has had to hopefully grow tax-free and because it's possible that you're in a lower tax bracket when you retire, than when you're in your peak earning years, assuming no dramatic upward shifts in tax rates. So, if you're looking to save for retirement anyway, then a 401(k) can be a good way to do it.

A final thing to be aware of with a 401(k) plan is that, in a sense, you're on your own. Yes, it can help you save for retirement, but unlike with a defined benefit plan, there's no guarantee that what you'll have in retirement from your 401(k) will be enough to meet your retirement needs. 

The extent it does is up to you, based on how much you save and for how long, and, determined by the markets based on how your specific 401(k) investments do.

A 401(k) also has the benefit that it can be quite easy to set up regular saving since the money goes straight from your employer to your retirement account, so you're not tempted to spend it.

Depending on the specifics of your plan, you may also end up saving more as your income grows if your savings come out as a percentage of your salary, assuming you remain below contribution limits. Contribution limits are currently $18,500 for 2018, excluding catch-up contributions.

Employer matching can be a nice bonus

One of the great things about 401(k) plans is about nine plans out of ten, offer some form of employer matching to them. This means that when you put in money, your employer will match at least a proportion of that money.

Sometimes you must have been with your employer for up to a year, and sometimes the matching can take a few years to vest, which means you'll need to remain with the company for a few years to get the match.

Nonetheless, this can be a fantastic benefit, especially if you're saving for retirement anyway. For many people, even if your 401(k) options are not ideal, then at least investing to take advantage of the matching benefit can be a sensible strategy. For example, if your employer offers a 100% match up to 5% of salary and you earn $100,000 then that's potentially an extra $5,000 every year if you take full advantage. Of course, the specifics of your particular 401(k) will determine how valuable any match is to you.

Self-directed brokerage widens choice

An increasing number of employers are offering self-directed brokerage options for 401(k) plans.

Currently one in three plans offer self-directed brokerage, up from one in four in 2015 based on Deloitte Defined Contribution Survey 2017 data.

A self-directed brokerage option can be extremely useful. This is because rather than selecting from a predefined menu of funds that are available within your 401(k) you can typically buy a much broader range of funds, like how you would at a brokerage.

This means that you are free to select perhaps less expensive funds, remember some funds are now free, or different asset classes than are available within the 401(k) fund choices. Of course, the goal here is not to select outlandish investment choices, but you may be able to cut your expense ratio or add certain asset classes.

For example, the same Deloitte survey found that most 401(k) funds don't offer TIPS, real estate or socially responsible investment options.

Furthermore, almost half don't have specific funds for emerging markets or different categories of fixed income such as high yield or Treasury bonds. While these options don't need to be part of everyone's portfolio, using the self-directed brokerage option may get you closer to the asset mix that's the best fit for you. If you haven't looked at your 401(k) in a while, you may want to check if a self-directed brokerage option is now available with your 401(k).

What options to pick

Selecting an investment within a 401(k) is an important decision.

Most plans offer bond a diversified bond and diversified global equity option. As I've detailed previously, these two funds can form the core of a portfolio. However, across all your 401(k) options, it is worth paying attention to expense ratios, since lower expense ratios can help lower your investment costs.

Also, here are a six portfolios from expert investors, that it may be possible to emulate depending on the set of options in your plan, or using self-directed brokerage option within your 401(k) if you have one. Though the allocation question can be tricky, picking a robust strategy and sticking with it, rather than swapping funds in and out every few months can be a smart move.

Nonetheless, the main thing to be aware of is your 401(k) employer match, and making sure that you consider investing up to that level if it makes sense for you, because a 401(k) match can be thought of as another benefit that your employer offers, and it could end up being far more valuable than a gym membership.

Also, though in the past investment options may have been narrow, now with self-directed brokerage choices, it's possible to avoid expensive or narrow investment options within a 401(k) plan.

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