How to invest a 401(k) depends on how many years you have left until retirement and on your personal level of risk tolerance. If you want to go for the gusto and see the highest possible performance for your investments, your 401(k) is the place to do it because of its numerous tax benefits. Regardless of which investment choices you make, the best thing is to put as much into it as you can afford and make occasional adjustments.
The Tax Issue
One recommended strategy is to aim to hold your best performers inside your 401(k) since dividend earnings and capital gains aren't immediately taxed but are instead reinvested and will compound over time. An alternative strategy is to keep investments that are likely to have strong capital gains outside of your 401(k) since the capital gains tax rate is lower than the ordinary income tax rate. There are merits to both strategies, and either way you need to stay informed about future changes to the tax code which may impact your strategy.
A 401(k) is the ideal place to hold equities, whether mutual funds or individual stocks. When you're young, time is on your side to ride out bear markets. You can't cash out before retirement, so you'll be less tempted to bail out in a downturn, only to face the later disappointment when the market bounces back. If you're a risk taker and want to invest aggressively, that is the best way to work your 401(k). Gains and earnings will grow without taxes for decades. High tech, emerging markets, small-cap stocks and other similar high risk, high reward stocks cry out to be within a 401(k) in your younger years. Even if you're willing to take risks, make sure you diversify your holdings so that a crash in one market sector won't destroy your account. Index funds are a solid core investment holding, but consider that their low turnover means that they are less subject to capital gains than other funds and therefore suitable for taxable accounts.
If your employer offers you stock in your own company, limit the amount you own to a small percentage of your holdings. Your salary and bonuses are already linked to the fortunes of your workplace. If the company goes under and you lose your job, you don't want your 401(k) to sink on the same ship. Stock options may be offered at a reduced price, and the company might match your contribution, so definitely take advantage of any special perks.
As you get older and approach retirement, you'll want to transition some of your money from stocks into bonds. If you're a nervous investor or if bond markets are performing well, you can keep some retirement money in bonds even when you're young. Corporate bonds can have generous returns and help diversify your assets. A dumb idea, however, would be to put municipal bonds inside a 401(k) since they are already tax free.
- Making a financial plan image by Allen Stoner from Fotolia.com
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