Saving for retirement is a marathon, not a sprint and the sooner you start, the better.
As reported by the Motley Fool, 55% of non-retirees have a 401(k) or 403(b), while 25% have no savings for retirement. What category applies to your situation?
If you’re part of that 55% or are considering the benefits of a 401(k), it’s essential to understand what this long-term investment account entails so that you can avoid making some of the most common (and costly) mistakes. The types of errors that lead to stagnant growth and less financial freedom as you head into your golden years.
Here’s what you need to know today to protect your future for years to come.
Why your 401(k) matters
Whether you have been adding to your 401(k) for years or have just recently started, saving for your retirement in a 401(k) is one of the smartest moves you can make. Unfortunately, Social Security alone will not likely cover your living expenses. Overall, these monthly benefits will likely only replace around 40% of your former paycheck—if that.
This lowered monthly amount is why a 401(k) is so beneficial, especially if your employer will match your contributions. Not only will a 401(k) help reduce your tax burden, but the longer you leverage this investment account, the less impact you’ll feel about short-term volatility in your portfolio. It’s all about portfolio diversification.
So, yes, your 401(k) is an excellent way to accumulate savings for your future. However, if you’re not seeing the type of growth you anticipated, here are some reasons why that may be—and what you can do about it, especially as a young investor.
You’re not optimizing your full employer match
If things that offer value are priced at buy-one-get-one-free, your next move is often a no-brainer, especially when it comes to something as critical as your retirement savings.
Most employers that sponsor 401(k) plans will match worker contributions. But if you are not putting enough money in your 401(k) to meet that match, you’re leaving money on the table.
On average, most 401(k) portfolios generate an average annual return of 5-8%, depending on investment selection, contributions and fees. Let’s say you pass up on $1,200 a year in free 401(k) money from your employer, at an average annual return of 7%. That means after 30 years, you will have missed out on over $110,000—some of which you could have wisely invested.
You’re paying too much in fees
Like any investment, you need to know what you’re paying in fees. Not all 401(k) funds are created equal concerning fees, so you may be paying far more than you need to be.
Most 401(k) plans offer a combination of index funds and actively managed funds. The latter option is relatively expensive concerning fees. So, step one is understanding the difference between actively managed versus passive funds.
You need to read the fine print, understanding fund performance, expense ratio and management fees at the very minimum.
If you are currently paying high fees, it may be time to switch things up. Although actively managed funds can yield high returns, the fees are hefty. If you are looking to reduce fees, index funds are a good bet because the fees are less and can outperform actively managed funds. Also, invest your money strategically to help offset any fees you pay.
If there is an alternate option to the fees you’re currently paying, take it. The more aware you are, the better.
Your investment plan is too safe
Yes, the stock market can be volatile, which isn’t very comforting for many.
Your thought process is, you work hard for your money, so gambling with it is scary. This thought process is completely understandable. However, if you load up your 401(k) with only bonds, you may be disappointed how slowly your savings grow. The example above was based on a seven percent return, slightly below the stock market average.
In contrast, you may only see an annual return of 4% with bonds. Over 30 years, that’s a significant difference. Sure, you’ll still have money put away, but not as much as you may have liked or anticipated.
Remember, it pays to diversify your portfolio. Invest in a reasonably aggressive (but intelligent) fashion, especially as a young investor who is many years away from retirement—for example, investing in real estate to earn passive income.
Investing takes time
If you have invested in a properly balanced 401(k), it will take time to see any significant progress.
A spike in returns often comes down to compound interest, which can take off 10-20 years of saving and investing. When you reinvest the income earned on an asset, you can benefit from the power of compounding interest, which is the interest calculated based on both the initial principal and the accumulated interest.
Since investing does take time, starting early is one of the best tips out there. If you have the option of a company 401(k), don’t view it as an optional benefit—view it as a wealth-building tool. It’s not too late to start, even if you have next to nothing.
Several online calculators are available to help you better visualize a hypothetical scenario. For example, if you’re 30 years old and have a balance of $100 in your investment account and start making an annual contribution of $4,000 with a 7% annual rate of return, by the time you’re 65 years old, you would have a balance of $606,751 ($466,651 in earnings).
The annual rate of return is important here. If your goal is to retire at 65 and you’re 35, without anything invested in a 401(k), you will need to invest more each year to reach the same goal you had when you were 30.
A 401(k) is one way to save for retirement—not the only way. There is a lot of value in the potential of a properly balanced 401(k). However, there are also plenty of other ways to invest your money. Some of the factors to consider include:
- Investment amount. The more capital you invest, the greater the growth potential.
- Time. The longer you invest, the greater the opportunity for growth.
- Return. The more significant your return, the faster you can achieve wealth.
Real estate investing is one way to diversify your investment portfolio. This market is extremely profitable, remaining one of the most lucrative investments you can make.
Unfortunately, some barriers often prevent investors from benefiting from the real estate market. For example, property management can be challenging and access to real estate is costly.