Saturday, August 20, 2011

Navigating Your 401(k)

As a new entrant into the working world, I was recently faced with the task of figuring out what my 401(k) options were and deciding on an asset allocation appropriate for my age. Asset allocation decisions are such that if you ask 50 different experts for opinions on what an appropriate asset allocation is for a 22 year old, you are going to receive 50 different answers. The key in deciding on an appropriate allocation in your 401(k) is to take advantage of the opportunities you have as a young investor. 

First and foremost, I cannot stress enough the importance of maxing out your 401(k) contributions each paycheck while you are young. While preparing a monthly budget, you should decide on a pre-tax contribution percentage that will enable you to achieve maximum savings while at the same time ensuring you are not cash poor when all is said and done. For example, if you earn roughly $2,000 a paycheck and contribute 10% of your pre-tax pay to your 401(k) then that's an automatic $200 investment every paycheck. If you get paid twice a month, this adds up to $4,800 a year. The beauty of this is that the percentage is taken from your pre-tax pay so that you achieve maximum savings benefit and as a result, pay less taxes because you are no longer taxed on the $2,000 you would have earned, but on $1,800 instead. I encourage you to calculate what percentage you can afford to contribute and then maximize that - the benefits of the long-term time horizon you have are many.

Now comes the part where you need to decide what to invest in. While your plan sponsor may encourage you to invest in an target retirement fund, I would first check the total expense ratio of such a fund and its holdings. If the fund is actively managed, it is likely to have higher costs and may tend to drift away from its stated objectives as the underlying funds ebb and flow with the markets. Your best options are index funds and I would recommend an asset allocation along the lines of: 60% total stock market index fund, 30% total international index fund and 10% total bond market (or high yield) index fund. This asset allocation, while only a suggestion, will give you a broad exposure to the U.S. stock market, international stock markets and provide some bond exposure which you are likely to increase over time.

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