What to buy in your 401(k) if you don’t know where to start

You know your 401(k)?

There’s a reason the government puts a limit on how much you can contribute to it. It’s such a good deal that if there isn’t a limit, the government would lose out on so much money.

So why aren’t you taking advantage of it?

When we were living in DC, my husband had a coworker who was in the same career field as I am (Government contracting). She earned $140,000 a year but was super frugal. She hosted clothing exchanges to save money. Clipped coupons for McDonald’s and ate food past their expiration date. Basically, she really watched her money. But she also spent it on the really fun things that she loves, like flying to Colorado to go skiing and being part of a bowling league. She lived below her means and prioritized her spending on things that truly brought her joy. I wish more people lived like that.

About three years ago, my husband shared with me that he was talking to her about her TSP (401(k) equivalent for federal employees) and found out that she was only contributing 3% of her salary to her TSP. (Note: The federal government gives its employee a 100% match on the first 3%, and 50% match on the next 2%.) Here’s a quick calculation on how much free money she is leaving on the table just by not contributing 5% to get the full match:

2% x $140,000 = $2,800

50% x $2,800 = $1,400

$1,400 a year. (Based on a salary of $140,000–her salary actually goes up every year, so she is missing out on more and more money each year.)

Over the past three years, she has missed out on at least $4,200, cumulatively.

I don’t know what her favorite item is on the McDonald’s menu is, but my favorite item (before I started eating healthier) was the McChicken sandwich on the $1 menu. Assuming a 9% state tax, she would be able to eat one McChicken sandwich every day for 10 years and 6 months.

And here’s the kicker—she was invested in 100% bonds. Bonds, which are low risk, but also gives really low returns. She’s in her early 30s. When I heard that, I asked my husband why. He shrugged his shoulder and didn’t really have an answer.

I think it’s so ironic that she works so hard to save money in so many areas of her life, but the one area that would give her the highest return on her money is not being fully optimized.

Not only did she lose out on the company match, she also missed out on one of the greatest bull runs in history. While she couldn’t have predicted that (and no one can predict the market), being in her 30s, she still has so much time to recover from any market loses so being invested in stocks, even if it’s just 60% of her portfolio, would have given her a much better return on her savings.

If you want to maximize your time and earnings, you have to think of the big wins. What would give you the greatest return on your money with the least amount of risk? The free money from a company match, a 50% to 100% return on your money with little risk on your part, wins all around, even if your company offered really expensive investment choices.

So if you’re currently not contributing to your 401(k), at least to get the company match, why not? (And if you are even more ambitious, contribute the maximum allowed, which is $18,500 for 2018.)

If you have no clue what to buy once you’ve contributed to your 401(k), a good option is a life cycle or target date fund but if and only if the retirement plan administrator offered funds that have low management expense ratios (MERs) (0.50% or lower). When I was reviewing my nephew’s 401(k), I saw funds that charged 2-3% in fees. Vanguard, Fidelity, and Schwab usually have low-expense MERs. If your 401(k) doesn’t offer any funds with low MERs, contribute up to the company match, then open up a Roth IRA with Vanguard, Fidelity, or Schwab, and buy one of their life cycle funds.

How life cycle or target date funds work is, you pick a date in the future when you plan to retire and your asset allocation (i.e. the percentage that is invested in bonds and stocks) gets adjusted automatically as you get closer to retirement so that your investment portfolio becomes less risky (this just means your money gets allocated towards more bonds and less stocks with time).

For example, my TSP offers the following life cycle funds:

L 2020 (more bonds, less stocks = lower risk, lower returns)
L 2030
L 2040
L 2050 (more stocks, less bonds = higher risk, higher returns)

If I were a newbie investor who plans to retire in the year 2050, I would just pick the L 2050 fund and keep it simple. The beauty of target date funds lie not only in their simplicity, but also the fact that they can help you avoid costly behavioral investing mistakes. When you invest in individual stocks, it’s so easy to be tempted to buy and sell a stock every day when you are constantly bombarded with the news, or to adjust your asset allocation based current events. Research has shown that your behavior (trying to jump in and out of the market) will cost you more money than just keeping it invested for the long run. The important thing for those who are investing is to get started. Once you learn more about investing, then you can start building your own portfolio, determine the right asset allocation for yourself, and take off the (target date fund) training wheels.

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