Ultimate Guide To Building Wealth In Your 401(k) or 403(b)

Introduction

Before starting my own independent financial planning firm, I worked for over a decade at Fidelity Investments in their workplace planning and advice group. As a CFP®, I was responsible for providing advice to all their 401(k) and 403(b) plan participants. This included helping everyone from CEOs of Fortune 500 companies to 21 year-olds who were just getting started in their careers. I have literally seen thousands of 401(k) and 403(b) plans of all types, and I have also had thousands of conversations with these plan participants. I can confidently say that you won't find anyone who knows more about the ins and outs of these plans, and what makes people successful when investing in them. More importantly, I know what makes people fail at really getting the most value out of their employer retirement accounts. The goal of this guide is to teach you what to do and what not to do, so you don't have any regrets down the road when you are ready to start living off these savings in retirement. This guide will address the following:

A step by step guide for following a disciplined investing process so you can avoid making huge mistakes
Company match and contribution limits
Contribution types (along with some tax savings strategies and tips for choosing them)
The pros and cons of the 3 types of investment strategies available in your 401(k) or 403(b).
How to decide whether to rollover

There Are 5 Key Steps To Being a Successful Long-Term Investor In Your 401(k) or 403(b)

Goals

Before you can decide HOW you should invest your money, you first need to decide WHY you are investing your money.
An investment plan that is tied to a long term goal such as saving for retirement decades down the road will need to look a lot different than a short term goal such as saving for a down payment on a house that you want to be able to purchase in 2 or 3 years.
Generally, the longer the time frame you have to reach your investing goal, and the more money you need to pay for that goal, the more aggressive i.e. more risky your portfolio needs to be.
The shorter the time frame, and the less amount of money you need for your goal, the more conservative, i.e. less risky your portfolio needs to be.
Why is this?

Investment Risk Vs. Return

Generally speaking, the riskier the investment, the greater the long term return it will achieve because people need to be able to expect higher returns in order for them to be willing to take on this additional risk. These types of riskier investments will have more volatility, and can have greater negative returns than more conservative investments over shorter time frames. But over longer time frames, they should generate higher returns.
The more conservative the investment, the less likely you will experience negative returns, but because you aren't faced with the volatility of riskier investments, your returns will be lower and your portfolio wont grow as much over the long run.
So using the previous examples, if you are decades away from retirement, the investments you use to fund your retirement goal need to be more aggressive. This is because you have enough time to ride out the ups and downs your portfolio will experience, and the greater long term returns will give you a better chance of having saved enough for retirement.
If you are saving to purchase a house in 2 or 3 years, you can't afford to be too aggressive with how you invest those savings because you don't have time to recover from any losses that a more risky portfolio may experience.

how goals affect portfolio risk

Asset Allocation

So what makes a portfolio more or less risky? It's asset allocation. The term asset allocation describes what percentages of your portfolio are allocated to the 3 main investment categories: Stocks, Bonds, and Cash (also referred to as short term investments).
As you can see from the chart below, over time stocks have higher risk so they generate higher returns. Bonds have less risk so they generate lower returns than stocks. Cash or cash equivalents have the least amount of risk so they generate the least amount of return.
As mentioned previously, a longer term goal should be assigned a portfolio allocation that has a higher percentage of stocks and a shorter term goal should have a portfolio allocation that has a higher percentage of bonds and cash.

portfolio risk versus return

Investments

Once you have determined what percentages of your portfolio should be in the stocks, bonds, and cash categories, you then need to decide which individual investments you want to purchase in order to create a portfolio that has the desired mix.
There are multiple ways to invest in stocks, bonds and cash, with mutual funds and exchange traded funds (ETF's) being two of the most popular ones.
Mutual funds and ETF's allow you to purchase a basket of stocks or bonds all at once instead of having to go out and purchase them individually. This allows you to diversify your investments in a more simplified and cost effective manner.
When it comes to investment selection, we believe on focusing on what you can control. Cost is one of the few things you do have control over when it comes to investing.
For this reason, whenever possible, we suggest using lower cost funds and ETF's. In your employer-sponsored retirement accounts, ETF's are generally not available so try to focus on using low cost mutual funds when available. Does this mean you should ONLY choose the lowest cost option possible? No. We believe there are some actively managed funds and ETFs out there that may have slightly higher expense ratios as compared to passively managed options, but over the long run, their returns have made up for their higher costs.
Tip: One of the most common mistakes I see people make is to simply pick the funds in their 401(k) or 403(b) with highest return over the past year. They assume because it has been a top performing investment recently, that will continue. However, it is actually extremely rare for a fund to be a top performer in it's category one year, and then be a top performer again the following year. One year performance is not nearly long enough to draw any reasonable conclusion as to how well the fund will perform over the long run.
When researching individual funds or ETFs, it's more important to look at the long term track record (10 years plus), the cost, its risk profile, and how that category of investment has typically performed during different business cycles and market environments.

Stay Disciplined

Once you have implemented your portfolio with the asset mix and investments that align with your goals, the next step is the most challenging...
Don't make emotional decisions to change the asset allocation of your portfolio unless your goals or situation has changed. For most people, this is easier said than done.
I apologize ahead of time for really trying to hammer this point home in the next few sections. But I think this is the single most important step and also the hardest. I focus on it because as an advisor, I have seen countless examples of people trying to time the markets and it cost them tens if not hundreds of thousands of dollars in the long run.

The 2020 Covid Crash & Rebound

First take a look at the chart above which reflects the year to date returns of the S&P 500 from January 1st through December 19th. The index dropped 33% between 2/19 and 3/25. Many investors panicked as the market started to experience a substantial decline in March. It's hard to knock them as they were only acting based on thousands of years of evolution that has hardwired our brains to be risk averse. The media knows this. So every time there is an event like this, they use fear-mongering to boost their ratings. The panic that was induced by the onset of the pandemic caused people to sell out of all of there investments at or towards the bottom of the stock market crash, essentially locking in their loss, and they never bought back in to reap the benefits of one of the fastest and largest stock market rebounds in history. As of 12/19, the major stock market indices are at or near all time highs.

Nothing New Here

This type of market correction and rebound has happened time and again. In fact, the market has ALWAYS rebounded after a substantial decline. Take a look at the chart below which shows the returns of the S&P 500 over the course of multiple negative political and economic events between 1999 and 2018. Think back to how you were feeling about your investments during each downturn. With each event, the media made it sound like the world was crashing down, but look how the markets performed over the long run.

S&P 500 returns over the long run

Experiencing these types of emotions when it comes to investing is completely normal. The key is managing them so that you don't make mistakes that could cost you dearly in the long run.
The average fund investor tends to consistently under-perform the overall markets because their emotions cause them to buy and sell their investments at the worst possible times.
They end up buying stocks at their peaks and selling at their bottoms.

how emotions impact market timing

This cycle can lead to substantially lower returns than if they had just stuck with the original mix of stocks and bonds that made the most sense for their goals...

average investor returns compared to market index

Jumping in and out of the markets and missing only a few days of returns could cost you thousands...

how market time reduces investor returns

Rebalancing

If your goals or situation haven't changed, the only time you should make changes to your investments in your portfolio is when market fluctuations have steered your original intended asset allocation (and therefore your portfolio risk) off target.
Rebalancing involves selling investments that have increased in value and using the proceeds to buy investments that have not done as well. This may sound counter intuitive, but this actually helps you to buy low and sell high (good for returns) while keeping your original desired mix of stocks, bonds, and cash.
In the below example you will see that during periods of high stock market returns, if you ignore your portfolio and never rebalance it, you will all of a sudden have a portfolio that has substantially more stock exposure and therefore risk, than you originally deemed appropriate.

why rebalancing a portfolio is important

Rebalancing Applies In Down Markets Also

The opposite can happen during periods of stock market declines.
During a stock market slump the individual stock holdings in your portfolio will lose value, which means you will find your overall portfolio containing a lower percentage of stocks and a higher percentage of conservative bonds. This makes your portfolio too conservative and reduces your ability to achieve the long term growth that you need to achieve your goals.
Lets say for example you are supposed to have a 70/30 mix of stocks to bonds, but the stock market has under-performed recently and now your portfolio is at a 60/40 mix. The savvy investor would know to sell 10% of their bonds holdings (which haven't lost value like stocks because they are more conservative).
They would then take the proceeds from selling those bonds and buy enough stocks (which are on sale) to bring their portfolio weightings back up to a 70/30 mix of stocks to bonds.

Company Match & Contribution Limits

In addition to deciding which investments you should own in your employer-sponsored 401(k) or 403(b), you need to decide in what form you want to put your money into those investments. There are a few things you need to know.
You ALWAYS need to find out what your company match is. This is the percentage of your salary that your employer contributes on your behalf as long as you are making your own contributions. They may also just contribute a flat dollar amount instead of a percentage.
For example, let's say they state that they will provide a dollar for dollar contribution up to 4%. This means if your salary is $100,000 and you are contributing 4% yourself, you will be putting $4,000 into your account over the course of the year and so will your employer. Since this is free money and basically a guaranteed 100% return on your contributions, you should always do everything possible to at least contribute enough to receive your full company match.
Ideally, you are able to contribute a much higher percentage than that, regardless of what the employer match percentage is. The more you save, the more likely it is you will be able to make work optional when you want to, and a 4% contribution rate simply wont cut it.
*TIP 1: If you are maxing out your contributions each year, your employer may cut you off once you hit the limit and this may cause you to miss out on company match. For example, let's say you reach the 2020 contribution limit for people under 50 of $19,500, in September. If your employer tracks this limit and cuts you off for the rest of the year, you will no longer be making contributions which means your employer won't be either. To avoid this, some plans provide what's called a True-Up matching contribution at the end of the year to provide you any matching funds that you missed out on by hitting the limit to early in the year. If this situation applies to you, it's important to know what your employer does when you hit the max contribution limit.
#TIP 2: If you switch employers in the middle of a calendar year and make contributions to both plans, it is your responsibility to track your contributions and make sure that between both plans, you don't exceed the limit.

401(k) & 403(b) Contribution Types

These days, many employer plans are allowing you to make Roth Contributions (not to be confused with contributions to a ROTH IRA which is an individual account that is completely separate from your employer). You need to find out if this is an option and decide if you should make your contributions in the form of Roth savings, or if it makes more sense to contribute in the more traditional manner of pre-tax contributions.
What's the difference?

Keep in mind that even if you contribute Roth money into your 401(k) or 403(b), your employer match will always be in the form of pre-tax dollars so it's common for people to have both types of money in their employer-sponsored retirement accounts.
This is not an all or nothing choice. If your plan offers the option of Roth contributions, you can direct some of your contributions towards Roth, and some towards pre-tax contributions.
As you can see from the chart, one of the biggest benefits of being allowed to make Roth contributions in your 401(k) or 403(b) is that unlike a Roth IRA, there are no income limits. It doesn't matter how much money you make, if Roth Contributions are a plan option, you can make them.

How To Choose Between Pre-Tax and Roth Contributions

You should consider your current and future earnings potential as this will determine your marginal tax brackets.
If you are early in your career, and you expect your earnings to increase in the future then consider making Roth contributions.
If you are at or near your peak earnings now, then you may want to consider making Pre-Tax contributions. But this is just a general rule of thumb and there are exceptions.
Even if you are early in your career, if you are already a high income individual and solidly making six figures, it may be better to take advantage of Pre-Tax contributions as much as possible. This is because there is a good chance your spending levels in retirement wont be as high as your income levels now. So as you withdraw your Pre-Tax money in your retirement, it gets taxed at a lower rate than what you would have to pay on those amounts if you contribute as after tax now. Yes, everybody is concerned that tax rates will be higher decades down the road, but the goal with this strategy is that even if they do increase, that will be offset by how much less you end up spending in retirement as compared to what you are earning while working.
Tip: If you have student loans and are enrolled in an income-driven repayment plan with the goal of achieving loan forgiveness, you almost ALWAYS should be making Pre-Tax Contributions. This is because when you are targeting loan forgiveness, the goal is to pay as little as possible towards your loans each month. By making Pre-Tax contributions, you are reducing your income and in turn reducing your monthly payment amount.
You can learn much more about student loan debt strategies HERE

*Super Awesome Roth Conversion Trick In 401(k) and 403(b) plans

Ok this isn't really a trick. But it is a benefit that in my experience, most people aren't aware of.
The first thing you need to know is that some plans actually offer a third type of contribution source in addition to Pre-Tax and Roth: After Tax
If your employer doesn't allow After Tax contributions, you can skip to the next section as this unfortunately won't apply to you.
After tax contributions are treated differently from Roth contributions (even though both are made with after tax dollars) in two ways.
First, unlike investment earnings made from Roth contributions, earnings from After Tax contributions are taxed as if they are Pre Tax contributions when they get paid out of your retirement account. (Not so good).
Second: After tax contributions do no count against the cap on how much the IRS lets you contribute as Pre Tax or Roth in your plan ( known as your deferral limit, which for 2020 is $19,500 for people under 50). This is good.
For 2020, the IRS actually allows for a total combined amount of contributions of $57,000 into your plan. This amount includes your own personal Pre-Tax, Roth, After tax, as well as any company matching contributions. For example, if your employer does not provide any company match, you could max out your Pre tax or Roth Contributions at $19,500 for 2020, and still contribute an additional $37,500 in After Tax Contributions ( if they are an option in your plan).
Some plans will then let you request what is called an In-Plan Roth Conversion. This means those after tax contribution amounts get recharacterized as Roth sources of money, and therefore are treated as, and reap the benefits of Roth money moving forward.
The beauty of this is that the IRS allows these In-Plan Conversions regardless of your income level. So a high income individual could potentially be stocking away tens of thousands of dollars per year in Roth savings. This is much higher than the current 2020 limit of $6000 per year allowed in a Roth IRA for people under 50.
IMPORTANT: When you request an In-Plan Roth Conversion, any investment earnings that you have made off of your after tax contributions that get converted, will be taxed as ordinary income for the year the conversion is made.
For this reason, some people will request multiple In-Plan Roth Conversions throughout each calendar year, so the earnings from after tax contributions don't have time to build up and become taxable. Some may go so far as to request a conversion the very next day following their after-tax contribution, essentially making every in-plan conversion completely tax free. But the ability to do so is subject to how often your plan allows them.

The 3 Methods for Selecting and Managing Your Investments In Your 401(k) or 403(b)

So how do you actually go about selecting and then rebalancing the investments in your employer retirement accounts?
Generally you have three options.
One is not necessarily better than the other. It just comes down to how much expertise, experience, time, and desire you have to go through the investing process. In the following section we will break down all three options.

Option 1: The Self-Directed Approach

This option is for those who need little or no help with their investments
They are willing and able to spend the time necessary to research and select investments for their portfolio initially, as well as perform regular rebalancing.
If you go this route, you would just pull up the menu of investment options in your plan, and designate what percentage of your portfolio you want to be in various individual funds.
The biggest benefit of this approach is that you aren't paying any additional management fees aside from the individual expenses of each fund. You also have full control in customizing your portfolio.
The biggest drawback to this approach is that it requires you to put in extra time that you may not have to be successful. And it also requires you to stay disciplined and avoid making any costly mistakes based on emotional reactions to the markets.
Tip #1 for this approach: Some plans have free tools available to help you self direct your portfolio. They may offer an option to receive a model portfolio based on the answers you provide to their questionnaire. The model will recommend exactly how much of your portfolio should be invested in each plan investment option given your current situation. For example, it will come out and say you should have "X" percent of your portfolio in fund A, "X" percent in fund "B", and so on. While there is no additional charge for this, your portfolio will NOT be rebalanced for you. This means you would still need to monitor your portfolio after implementing the recommended strategy, and know what trades to make to keep it at the desired level of risk.
Tip #2 for this approach: If you really are self-directed, and you truly enjoy going through the entire investment process, you may want to inquire if your plan offers an expanded menu of investment choices. For example, with plans serviced by Fidelity, you have your basic core investment options which usually consists of a set of mutual funds. But then some plans also offer what's called a Self-Directed Brokerage Link. This feature gives you access to invest your 401(k) or 403(b) money in additional fund options and sometimes even stocks. You have to separately sign up for this option.
In my experience, most people do NOT have the time, experience, and willingness to properly self direct a portfolio in their 401(k) or 403(b). It's important to be honest with yourself if you decide to take this approach. I have seen countless examples of people who have decided to go this route with the best of intentions. They received a model portfolio, and implemented the recommended strategy, but then life got busy, and they forgot or simply neglected to rebalance and update their portfolio moving forward.

Option 2: Target Date Funds

A Target Date Fund is a single fund approach to being diversified. That is because inside of this single fund, there is an allocation of other funds from all 3 major asset classes: Stocks, Bonds, and Short Term investments.
This is more of a hands off approach to investing in your employer plan because the selection of investments and the rebalancing is done for you. Because of its simplicity, it's generally the default option. So if you start making contributions to a new 401(k) or 403(b), but you forget to make an investment selection for those contributions, this is where your money will most likely end up.
Generally these funds come in 5 or 10 year increments. The idea is to choose the fund matched to the year that is closest to when you expect to retire. For example, you may see a list of target date fund options in your plan that are labeled Target Date 2020, Target Date 2030, Target Date 2040, and so on. If you expect to retire in 2048, the idea is that you would choose the 2050 fund. They may have their own unique names depending on what investment firm manages the funds. For example Fidelity calls their version of target date funds their Freedom Funds.
As the years go by and you get closer to the target date of your selected fund, the asset mix inside of it becomes more and more conservative. This means that gradually and automatically, the fund will hold less and less in stocks and more and more in bonds and short term investments. So a 2050 target date fund will hold most of its money in stocks since that fund manager knows people who invest in that fund are young, so they can afford to take on more risk right now in exchange for higher returns. A 2020 target date fund will hold much less in stocks because that fund manager knows people who are invested in it, are at or close to retirement. So they can't afford to take on as much risk.
The biggest benefit of this approach is that it requires less time and effort from the investor.
The biggest drawback is that it is not a very customized approach. The fund manager decides how much risk you should take with your portfolio based on your age. That's it. They don't factor in anything else such as your income, other investment savings, and expenses. Two people who expect to retire in the same year could actually need a very different portfolio depending on their situation and target date funds don't account for those differences.
Tips for this approach: Please, Please, Please, don't invest in more than one target date fund in your 401(k) or 403(b). I used to see this all the time. Someone would own 5 or 6 target date funds figuring they were being more diversified with their portfolio. The reality is that caused them to be LESS diversified. Why is this? Because those target date funds are actually funds of other funds, so they ultimately own stocks in a lot of the same companies, just with varying degrees based on the target retirement year. By owning multiple target date funds, you could end up being overly concentrated in one single company's stock which is never a good thing. Just being in the one target date fund should be enough to be properly diversified.
Also be aware that not all target date funds are created equal. A 2050 fund being managed by Fidelity probably does not have the same ratio of stocks to bonds as a 2050 fund run by Vanguard. This means they have different levels of risk even though they are designed for the same target year. Long story short, know what you own.

Option 3: A Fully Managed Account

Many 401(k) and 403(b) plans offer a managed account service. For example many Fidelity plans offer either Fidelity Portfolio Advisory Services at Work, or management through a third party, Financial Engines. When you enroll in a service like this, you are delegating the management of your portfolio to a third party professional.
They will take care of selecting your asset allocation, choosing how much of each available investment option should be in your portfolio, and rebalancing.
Because they are doing all the work for you, there is an extra fee associated with this. Generally, this fee is charged as a percentage of the dollar amount that is inside of your 401(k) or 403(b).
Keep in mind that this percentage management fee is in addition to the individual underlying fund fees.
But the additional fee may very well be worth it for people who do not have the time, expertise, or willingness to properly manage their own portfolio.
The benefit of this option is that you are delegating your portfolio management to professionals. This helps to avoid some of the emotional investing mistakes that people tend to make on their own. Secondly, this option i s usually more of a customized approach than target date funds as the portfolio manager will generally consider more details of your financial life when determining how your portfolio should be invested. Lastly, even though there is an additional management fee for this service, when it is inside of a 401(k) or 403(b), this fee is lower than you would usually pay for the management of an IRA.
One drawback to this approach is the additional cost and the fact that you don't really have much say in how your portfolio is managed ( although this could be a good thing). Secondly, you are paying a professional for management, but when it comes to them selecting your investments, they are handcuffed to the menu of choices that your employer provides. So If your employer only gives you one or two options in each investment category, stocks, bonds, and short term, you may better off saving the management fee and using the free model portfolio tools to do it on your own.

Should You Rollover Your 401(k) or 403(b) After Your Employment Ends?

This is a loaded questions and it really comes down to your personal situation. I recommend reading this blog post I wrote about the subject first.
You just need to be aware that many advisors get paid off of rollovers so they have a very real financial motivation to convince you to rollover your account to an IRA through them.
But in many cases it makes sense to leave your investments in your old employer plan, or roll it to your new employer plan.
You need to compare the overall costs, investment choices, and resources available in your employer plans and IRAs when deciding what to do.
Also keep in mind that your 401(k) or 403(b) may provide better protection against lawsuits (although in many states you either have unlimited protection in an IRA also, or up to $1 Million in protection).
If your new plan has lower costs, and a lot of tools and resources to help you manage the portfolio, it may make sense to roll your old plan into that. If the opposite is true, there shouldn't be any reason why you can't keep your investments in your old plan, while at the same time start contributing to your new plan ( you can't keep making contributions to an employer's plan once you stop working for them).
If you really are self directed and prefer having access to the universe of investments instead of being limited to your employer's menu, generally an IRA is the way to go.
Also, if you think a managed account is the best strategy for you, and that isn't an option in your employer plans, should consider an IRA.

Key Takeaways

All investing involves some types of risk. The key to long term success is to focus on what you can control. This includes your investments cost and your asset allocation.
The number one obstacle when it comes to achieving your investment goals, is not political or economic events, its you.
Keeping your emotions in check and approaching your investment decisions methodically will lead to long term success.
It's important that you don't just figure out WHERE to invest your money in your 401(k) or 403(b). You need to also determine HOW MUCH and in WHAT FORM you save in your accounts.
You need to be completely honest with yourself when determining which investment approach makes the most sense ( self-directed, target date funds, professional management).

The Ultimate Guide to Building Wealth In Your 401(k) or 403(b)