How to Make Your 401(k) Work Best for You

October 30, 2015

Connect Member

Wealth Advisor, HoyleCohen LLC. Empowering women to achieve professional and personal success.

I recently met a woman — I’ll call her Sue — who is a well established attorney in her sixties and wanted to know if she was on track to retire in 10 years. She envisions retirement as traveling to far-off places, living in the same big home she’s had for years, and having very much the same lifestyle that she has now. Sue makes good money and lives a very comfortable life, but within a few minutes of reviewing her accounts, it became painfully clear that there was no way she could retire in 10 years — or 20 years, or ever — with the same quality of life she has now unless she made some substantial changes.  As hard as she has worked, and as successful as she has become, Sue never saw the importance of saving for her retirement. Now with her 10-year retirement goal and very little money saved, she must make up for lost time.  

Unfortunately, Sue’s story isn’t unique. Nearly 50 percent of working women are not confident they can retire with a lifestyle they consider comfortable, according to the 2014 Aegon Retirement Readiness Survey. But why? There’s a saying, “It’s not what you make; it’s what you keep.” Often, the difference in people who successfully plan for retirement comes down to whether they are savers or they are spenders. The Aegon survey also states that one-third of women consider themselves savers, which leaves quite a few in need of a savings plan. The good news? If you have a 401(k) at work, you have a terrific tool at your disposal. Depending on the specific plan, you may have the ability to lower your taxes, get free money (from your employer’s match program), build savings automatically, and have tax-deferred growth.

But in order to maximize your 401(k) and retirement, you need to know how to make your plan work best for you. To start, ask your company’s benefits or HR department for the details of your plan so you can familiarize yourself with its specific features. Once you have that information, follow these five steps to be well on your way to a comfortable and content retirement.

1. Contribute as much as possible.  A good rule of thumb is to contribute 10 percent of your salary to your 401(k) plan. If you can contribute the maximum ($18,000 for 2015 if you’re younger than 50, and an additional $6,000 if you’re older than 50) and still live comfortably, do it. If your company matches contributions, this is free money to you! At the very least, contribute enough to take full advantage of the corporate match.

2. Start small. If you’re not already taking advantage of a 401(k), start now, even if you can only contribute a small amount. Each time you get a raise or a bonus, earmark a portion for your 401(k) plan. You won’t miss the money if you don’t count on it in the first place. Just start right now! Compound interest (when your interest earns interest) is a powerful thing.  

3. Invest your money wisely. The choices in 401(k) plans can be daunting. I’ve seen plans that have pages upon pages of mutual fund options, making it extremely hard to determine which are the best choices. Make this easy for yourself: If your plan offers target date funds, these are often a good choice. Target date funds are based on your expected retirement year, and the allocation in the fund changes the closer you get to your retirement.

It’s important to understand the stock allocation (how much of your contribution is kept in stocks) in the fund you choose, though, because it’s not consistent across funds. Some options have higher stock allocations than others, and you’ll want to make sure whatever you choose is aligned with your tolerance for risk and the time frame you have before needing the money. (Generally, the younger you are, the more risk you can take with stock allocations, because you’ll have more time to recover any lost funds.)

4. Split your contributions between a traditional and Roth 401(k). If your plan includes both traditional and Roth 401(k) options, I suggest a split between the two. The difference between these is when you pay taxes: For a Roth 401(k), your contributions are made with after-tax money. You won’t get a tax break now by lowering your taxable income like you will with a traditional 401(k), but when the time comes to take the money out for retirement (at least five years after opening the account), withdrawals will be tax-free. Contributions to traditional 401(k)s are made with pre-tax dollars, meaning you get a tax break now, and gains on your investments grow tax deferred. But, when you’re eligible for qualified withdrawals, you will pay ordinary income tax on the distribution. If you have both choices, you can hedge your bets and split up your contributions — after all, you can’t know for sure what tax bracket you’ll be in down the road — and have both taxable and tax-free retirement income when you begin taking distributions in retirement.

5. Let the plan do its thing. It’s OK to check your balance here and there, but don’t get too caught up in it. Let the investments do their work. If you’re investing in stocks, anticipate some volatility in the balance, and don’t let it sway you. Stick to your long-term plan. Revisit your account investments once a year to make sure they still make sense, but try not to make changes more frequently than that.

When 401(k) plans were introduced, they were meant to supplement other retirement sources like Social Security and defined benefit plans. Nowadays, 401(k) plans are even more important because they tend to be the major source of retirement income for many of us, according to the California Credit Union.

The great news for Sue is that she has the ability to sock away a good amount of money for the next 10 years, although she will have to make changes to her lifestyle to avoid running out of money in retirement — something that could have been avoided if she started planning sooner. You can learn from Sue, and set yourself up for success, by starting to contribute to your 401(k) plan early and consistently.

Bridget Grimes is a wealth advisor at HoyleCohen and a member of the DailyWorth Connect program. Read more about the program here.