You’ve graduated college. You’re in your first job. And you’ve just become eligible to start contributing to your employer-sponsored 401(k).
In essence, you’ve two decisions to make.
How much to save for retirement
Experts often say you should save just enough to get the full matching contribution from your employer. The majority of employers will either match 100% of your contribution up to 3%, or 50% of your contribution up to 6%, or 100% of your contribution up to 3% plus 50% of the next 2%.
But saving only enough to get the full employer match probably won’t allow you to save enough to have the standard of living you want in retirement, some 40 years in the future. Instead, no matter whether you were automatically enrolled into your 401(k) with a default deferral rate or not, consider upping what you save toward retirement, including your employer’s match, to 15%.
That savings rate will give you the best chance of hitting savings targets by certain ages that show you’re on track for a comfortable retirement. By age 30, for instance, you should have half your salary saved for retirement and by age 65 you should have 11 times your salary saved, according to T. Rowe Price. Fidelity Investments’ rule of thumb is similar: Save 10 times your income by age 67.
How to invest your 401(k)
If you were automatically enrolled into your 401(k) it’s likely your money is being invested in a qualified default investment alternative, a QDIA, such as a target-date mutual fund. Typically, your employer is defaulting you into the target-date fund that matches your anticipated year of retirement. For instance, a 25-year-old who expects to retire in 42 years would be invested in a 2060 or 2065 target-date fund.
One big benefit of target-date funds: They use a mix of asset classes that become more conservative over time.
But should you use the target-date fund or choose another option? Usually, you’ll have three or four choices: Build your own portfolio from the 20 or so investment choices on your 401(k) menu; a target-date fund; a brokerage account that allows you to build your own portfolio with all types of investments; or a managed account, in which a professional adviser creates and manages your 401(k) plan for a fee.
If you’re young and just starting out, and don’t have assets in other types of accounts, the target-date fund probably makes the most sense. The mix of asset classes will at least match your time horizon. But as you age, as your assets grow, and as your financial matters become more complicated, you might want to consider either a managed account or building your own portfolio.
And if you do build your own portfolio, consider your time horizon, risk tolerance, and investment objective, and your ability and desire to rebalance your portfolio when necessary. And don’t, if you do decide to build your own portfolio, make the mistake of investing an equal percent in all the funds offered in your 401(k). This strategy doesn’t really reflect your personal circumstances.
Best case, you’ll also factor in your human and financial capital, and even the present value of your Social Security benefit, when constructing your retirement portfolio. In his book, “Are You a Stock or a Bond?”, Moshe Milevsky makes the case that you should invest less in stocks if your human capital, the income from your job is risky, and more in stocks if the earnings from your job is stable.
Another factor to consider: If you’re young and expect to be in a higher tax bracket in retirement, and your company offers a Roth 401(k) option and matches your contribution, consider saving for retirement using that account instead of a traditional 401(k). Yes, you’re contributing after-tax dollars. But the money grows tax-free, and the distributions are also tax-free. And that’s not the case with traditional 401(k)s; though contributions are pretax the distributions are taxed as ordinary income.