The IRS describes 401k plans as a tax-deferred compensation plan allowing employees to save a portion of pre-tax income. These funds can be invested and grow, untaxed, until they are withdrawn at retirement.
Investing in a 401k plan is a wise choice, as many employers offer a matching contribution program as a company benefit. Before investing, understand your risk tolerances and your plan’s investment options.
Investing is a form of risk taking. Individuals invest in companies by buying stock or bonds, and business management uses this money to grow the business. Investors hope to earn a return on their funds in the form of dividends, interest payments or the increase in a stock’s value. Risk tolerance is important because when you invest, you run a chance of losing your money.
Your level of risk tolerance will be determined by your investing goals, your investing time horizon and how much risk you can take and still sleep at night. Your investing goals will include either income generation or capital growth, or a combination of both. Stocks generate income through the production of dividends, and capital grows as stock prices increase. According to Investor.gov, the stock market historically has provided around 10 percent returns on an annual basis. Bonds generate income through interest payments, and some may be structured to provide a return based on the bond’s price.
Your investing time horizon depends on your age. If you’re in your twenties or thirties, you can be more aggressive with your investments, taking more risk and hopefully generating higher returns over a longer period. If you are nearer to retirement age, you may want to take less risk, investing in stocks or mutual funds (collections of stocks and/or bonds from different companies) that focus on producing income and the preservation of capital.
Knowing how much risk you can take and still sleep at night is a little trickier. Choose investment products that offer a balance between risk and reward that will let you be comfortable given the chance that your investment will lose money, and will keep you happy knowing that your money is growing at a satisfactory pace.
401k investment options differ by employer, but most offer a balance of equities, company stock, bond funds and guaranteed investment contracts. Select investments that reflect your risk tolerance, as discussed above. Equity funds and company stock are generally riskier than funds focused on income generation such as bonds or guaranteed investment contracts. Your 401k portfolio should be diversified across investments, with the degree of diversification in any investment category being determined by your risk tolerance.
Review your investment selections annually and reallocate as your risk tolerances change during your investing life.