How should you invest your 401k plan?
Investing in your 401k at work may seem easy, after all you’ve only got so many options to choose from. In fact it’s a bit more difficult than you may think.
We’re often asked “how should I invest my 401k” so this Whiteboard Wealth video briefly explains some of our thought processes.
#1 Asset allocation
You need to consider your entire investment portfolio. Looking at each component separately and investing them differently just leads to randomness.
It’s important to have an overall asset allocation plan that matches well with your risk tolerance, risk required, and risk capacity. A good start is the risk questionnaire we have here.
#2 Asset location
If you invest in a 401k plan at work you should be well aware of it’s tax advantages and disadvantages. For example, your investment dollars can be made pre-tax (or after tax if Roth contributions are allowed) and will grow tax deferred, but you’ll pay ordinary income tax on the distributions when withdrawn (assuming contributions were pre-tax).
This tax deferral of growth is powerful! If you had your investments in taxable accounts you’d be hit every year with the taxes due on dividends and interest payments etc. For this reason, you want to ideally put your WORST tax offending investments (commodities, reits, bond funds depending on rates, etc.) in your tax preferenced accounts like your 401k plan. So a tip would be to invest your 401k in tax INefficient investments first and backfill the rest of your asset allocation around those asset classes.
#3 Pick the best investments
Many 401k plans have horrible investment options. They’re actively managed, high cost, and poor performing.
Other 401k plans have brilliantly managed passive, low cost index style investments. If you have access to just a few of these funds to invest in your 401k plan, you may want to utilize those first and allocate the rest of your funds in taxable or other investment accounts. For example, if you have a great Vanguard 500 stock index fund and that’s supposed to be 40% of your $100,000 total portfolio and you only have $40,000 in your 401k plan, you may need to allocate 100% of your 401k to that fund. You’d then invest the remainder of your investment accounts in other asset classes outside of your 401k plan where you’ll have more investment flexibility.