Don’t sleep on the 401(k).

This pre-tax investment account can offer an average return of 10% per year, if you choose the right funds to invest your money. And as the chart below shows, a 401(k) is the perfect vehicle to get you all the benefits of compound interest.

The average rate of return on a 401(k) depends on what you invest in. Depending on the investments, you can expect returns of 3% or up to 10%. If you’re looking for the latter, consider investing your 401(k) in funds that track the S&P 500, which is the 500 largest publicly traded companies in the United States.

The S&P 500 represents about 80% of the total market value, making it a useful way to track overall market performance. Between 1926 and 2022, the average return of the S&P 500 and its precursor has been around 10%.

Although this is the average, some years have been much higher and others, like this year, have been lower. But overall, you can reasonably expect a return of around 10% on your retirement account, depending on a variety of factors.

It is important to note that a 401(k) is the shell you can put money in to be protected from taxes. And then from there you choose how to invest it. Most 401(k) plans have a few options that should get you closer to the average annual return.

Let’s take a closer look at 401(k) accounts and the returns you can expect.

What is a 401(k)?

A 401(k) is a way to invest your money that gives you more tax advantages than opening a brokerage account on your own.

“It’s a tax-advantaged retirement savings account that you can access through your employer,” says Amy Ouellette, Vice President, Products at Vestwell, an investment firm. “It’s a way to avoid taxes either now in the future, or a combination of both,” depending on whether you choose the traditional or Roth option (if available).

Most employers offer company matches, or free money, if you contribute to a 401(k) up to the required limit.

What is a good 401(k) rate of return?

The rate of return on your 401(k) depends on your asset allocation: the investments you have chosen, the length of your investment schedule, the amount of your contributions, and the type of fees you pay into your account. .

According to Vanessa N. Martinez, a former financial adviser and founder of Em-Powered Network, an advisory firm, experts look at returns in two ways. Conservatives think your average 401(k) return will be between 5% and 8%. Others say you can expect a return of between 7% and 10%. The difference depends on the investments you choose and your asset allocation for each fund.

In general, you want your returns to outpace inflation. If your returns “are lower than inflation, then you’re losing money in the long run,” says Ouellette. That’s why experts recommend low-cost broad index funds for long-term investments.

Typically, there are at least a few good options for investing with your 401(k), though you’re likely limited to the options offered by your plan provider. If you can find one that tracks the S&P 500 or the total market, or at least a large portion of the overall market, you can expect an annualized return of around 10%, which would be both the historical average and outpace inflation. This is the most ideal situation for your investments.

How to calculate a 401(k) annual return?

To run the annualized return calculation yourself, take your ending balance for a specified period – usually a year – and subtract your starting balance. This is your total growth dollars. Then, divide that amount by the opening balance to find the percentage increase in your balance over the period. For example, if your ending balance is $120,000 at the end of the year and your balance was $100,000 at the beginning of the year, you would subtract $100,000 from $120,000. Then divide $20,000 by $100,000 to find a return of 20% for that period.

“First and foremost,” says Ouellette, “make sure you compare it to the right benchmarks.

This means that you should not compare, for example, an S&P 500 index fund with a bond fund. This will let you know if your returns are performing against the index it is supposed to track. If there isn’t, “people often compare themselves to the S&P 500” because it’s an easy indicator of the broader market.

If you have made contributions, you will want to subtract them from your calculations. And if you’ve made multiple deposits or made withdrawals, the calculations can get more complicated. It’s also harder to look at your returns for multi-year periods, although the method above should give you a reasonably close estimate.

That said, most online brokers have the ability to display your annualized returns and will even calculate your return over a custom time period, so you don’t have to whip out the pen and calculator.

What factors affect your 401(k) returns?

It is very important to look at the expense ratio, or fees, associated with your investments which can invisibly eat away at your income. You won’t always see these fees. Instead, you will simply get a lower return, which can add up to thousands of dollars over the life of your investments. That’s why it’s important to choose investments with low expense ratios.

Diversification is also essential. Diversification means spreading your investments among hundreds or thousands of companies instead of just a few. “Think about diversification,” says Ouellette. “Certain types of investments or certain companies can be volatile.”

Age is also an important factor that affects your yields. You can also consider this as time spent in the market. The younger you start, the more compound interest works magic on your balance. Starting even a few years later can mean losing thousands of dollars down the line, so starting as soon as possible is the only factor that can produce the best returns.

401(k) Savings Potential by Age

Here’s the power of compound interest over time.

These calculations assume an average return of 10% with varying amounts invested over 20 years, and never adding a penny more. All earnings come from compound interest only. This is why it is so important to invest early and often. This gives your money time to grow on its own.

If you put $1,000 into your retirement account at age 20, you’ll have $45,259 at age 60 with no extra effort on your part. If you add $100 per month, that increases to $576,370.

The more you can contribute, the more spectacular the returns. If you can start with $50,000 and leave it invested for 40 years, you’ll have over $2.2 million. And even if you can’t start with that amount, adding regular contributions to your account is the next best thing you can do.

How to Get a Better 401(k) Return

Putting part of your check into a 401(k) is the first part of the investment. The next “important step is to go back and allocate those funds,” says Martinez. This means allocating your dollars to the funds you want to invest in. You don’t want your money to stay there. You have to invest it.

Many 401(k) plans have funds that are all stocks, all bonds, or a mixture of the two – an example of such mixed funds are target date mutual funds. Target date funds take the guesswork out of investing. They automatically allocate riskier investments to more conservative investments based on your age.

Finally, your savings rate and consistency are important factors. It is important to continue contributing at regular intervals to average your investments at dollar cost. This way you buy the market through all the peaks and valleys because no one can time the market. And by adding as much as your budget allows, you’ll also dramatically increase your yields over time.