FundAdvice.com - 401(k) Investors: your questions answered

Questions! Yes we get questions, and without further ado, here are answers to some of the most frequent ones.

What is 401khelp.com?

401(k)help.com is a service of Merriman, which also publishes FundAdvice.com and SoundInvesting.com.

Many 401(k) plans have significant shortcomings, and we have found that participants need plenty of help to make the most of what they have available. By law, employers are limited in the advice and help they can give employees; if they make recommendations, they leave themselves open to legal liability should investments not turn out the way employees wished or expected.

In addition, relatively few plans include all the important asset classes that investors need to obtain proper diversification. For these reasons, we developed 401khelp.com as an online resource giving help on specific plans.

Here you will find lists of the plan options available in some of the largest 401(k) plans along with our recommendations. If your plan isn’t there, you can learn the process by which we evaluate a plan and apply it to your own options.

I will soon leave my employer for a new job elsewhere. Should I leave my money where it is or move it to a Rollover IRA?

Most likely your best bet is the Rollover IRA unless you have very good low-cost options in your current plan without any additional expenses. Some 401(k) plans give you access to funds you can’t get elsewhere on your own, such as Dimensional Fund Advisors (DFA) funds, which we consider to be the best in the world. (Outside of a few employer plans, DFA funds are available only through select investment advisors.)

Unless you have a particularly compelling reason to want to stick with your present plan, you’ll probably be better off with a Rollover IRA. This will give you virtually unlimited choices so you can allocate your assets for best results.

I will retire soon. Should I move my 401(k) account elsewhere to a Rollover IRA for the same reasons?

Yes, the same reasoning applies when you retire and have the option to move your money to a Rollover IRA.

I have heard the term “stretch IRA” but I don’t know what it means. Can you explain this?

I’ll give you an overview. If you are interested, I suggest you proceed carefully, possibly with the help of an attorney.

The term “stretch IRA” doesn’t refer to any special form of registration or anything new created by Congress. Instead, it is a way you can designate a beneficiary in order to extend an IRA’s tax-deferred or (in the case of a Roth IRA) tax-free benefits for many years after your death.

If you die with IRA assets remaining, they pass to your beneficiary. If the beneficiary is your spouse, he or she can roll these assets into a new IRA and name anybody as the new beneficiary after the spouse’s death.

The rules are different if the beneficiary is not your spouse. Let’s say you designated your daughter as the beneficiary. At your death, she will be required to start taking minimum distributions based on her life expectancy. If any of your IRA’s assets are left when she dies, those assets would normally have to be distributed in a lump sum to her estate.

But with stretching, the IRA distributions can potentially continue longer, though not forever. To do this, your daughter could name her son as a successor beneficiary, extending the period of IRA withdrawals beyond your daughter’s lifetime. However, as I understand it, the rules say that required minimum distributions to any successor beneficiary (in this case to your grandson) cannot last longer than the original beneficiary’s (in this case your daughter’s) life expectancy.

This guarantees that the IRA will be completely distributed within a few generations. In an extreme case, you could leave your Roth IRA to a grandchild or even a great-grandchild – allowing tax-free earnings for (potentially) the better part of a century.

If you wish to pursue this option, I have two suggestions.

First, start by contacting your IRA custodian to see if it has adopted language in its IRA agreement that allows the naming of successor beneficiaries. This is essential to stretching an IRA as I have described.

Second, consider the practical aspects of leaving money to heirs. When somebody inherits an IRA, he or she is under no obligation to take only the required minimum distributions. Your beneficiary is allowed to take it all out and spend it at once. That could abruptly end your grand plans to stretch the tax benefits over more decades.

This means that a stretch IRA, for all its benefits, is not under your control. For it to work as you might hope, your beneficiary will need to be powerfully motivated to do what the psychologists call deferring gratification.

I am worried that my wife is too conservative with her 401(k) plan. I have adopted your 60/40 mix of equity funds and bond funds, but she insists on having nothing but fixed-income funds. I’m not sure I can persuade her to do otherwise, and I think maybe I should move to 100 percent equity funds in my own account. That would make my 401(k) more risky, but between the two of us we would have about a 60/40 mix. Is this a good idea?

What you are proposing is to treat these two accounts as a single portfolio, which is a good idea in most cases. Your wife has the right to invest her savings according to her comfort level, and you have the same right with yours. I see nothing wrong with your plan, though I suggest you discuss it with her and make sure she understands what you are proposing to do, and why.

You should also be sure you are comfortable with having your own money invested entirely in equity funds. If you aren’t careful, you could find yourself upset from losses in your own account instead of looking at the total of both accounts.

My wife and I have 401(k) plans with options that are quite different, and we’d like to make them work together as well as we can. How can we do that?

This is a relatively easy problem to solve if you and your wife are willing to work together. I can’t give you an exact formula, but here’s the general approach. First, agree on the overall asset allocation for the two plans. That is, how much should be in equity funds and how much in fixed income.

Let’s say for the purpose of simplicity that you want 50 percent in fixed-income and 50 percent in equity funds. Start with the fixed-income side and determine which plan has the best options. This shouldn’t be very hard. If you can put half the fixed-income portion in a short-term bond fund and the rest in a total-bond-market fund, you’ll be set.

The equity side is trickier because many 401(k) plans do not have adequate choices. Look at each equity fund in the two plans and use Morningstar.com (which is better than the fund name) to determine its asset class. We recommend nine: U.S. large-cap, U.S. large-cap value, U.S. small-cap, U.S. small-cap value, international large-cap, international large-cap value, international small-cap, international small-cap value and emerging markets. Ideally, you would allocate 12.5 percent each in the U.S. asset classes and 10 percent each into the international ones.

Because few 401(k) plans have entries in every recommended asset class, you will have to do the best you can.

With a list of your options sorted by asset class, choose the best fund in each category. Your best choice will be an index fund. If you don’t have an index fund, look for a no-load fund with very low expenses. I know it’s always tempting to choose a fund based on its past performance, but remember you are investing in the future, not the past. A level of expenses is much more likely to persist into the future, and is thus much more predictable, than is a level of performance.

Once you have chosen the best fund in every asset class, see how close you can get to the suggested percentages outlined above. Start on the assumption that you’ll split the total equity portion half-and-half between U.S. and international funds.

Chances are good that one plan will have more high-quality equity choices than the other. Concentrate your equity holdings in the plan with the better options and use the other plan for more of your fixed-income funds.

You will probably find that you have only one or two international funds to choose from, most likely large-cap ones. Although we recommend having half your equity exposure in international funds, in this case you could reduce your international exposure on the equity side to 33 percent if you have only one international asset class or 40 percent if you have funds in two international asset classes. In that case, divide the rest of your equity investments equally into four parts and invest in the four U.S. asset classes we recommend.

I realize it’s impossible to give you an exact formula because of the many “moving parts” you may find in a pair of 401(k) plans. But if you follow this approach, you’ll be on the right track to making the most of your two plans.

It’s almost inevitable that your plans will leave out some of our recommended asset classes. That’s where your non-401(k) assets can balance things out, whether in an IRA or a taxable account.

My company will match contributions up to 3 percent of my pay, or about $2,000. I know that I should take full advantage of this. But should I contribute more even if it’s not matched?

You are right: You should definitely contribute enough to get that employer match. If you don’t, it would be like refusing an offer of free money. And you should definitely save more than $2,000 a year toward your retirement. But your 401(k) isn’t necessarily the best place for that additional money.

Our general formula for the priority of retirement savings is this: First, put enough in your 401(k) to qualify for the full match, if you have one. Second, maximize your Roth IRA each year (and your spouse’s too, if you are married). Third, make additional contributions to your 401(k). Finally, invest additional money in taxable accounts.

The Roth IRA is a great tool for investing in asset classes that aren’t available in your 401(k), so use it to balance things out and get the right asset mix. Most likely this will lead you to own small-cap value funds, emerging markets funds and small-cap international funds in an IRA instead of a 401(k).

In general and to the extent that it makes sense, place more tax-efficient assets such as equities in taxable accounts and less tax-efficient ones such as fixed-income and real estate funds (if you use them) in sheltered accounts like your IRA and 401(k).

How do I identify the asset classes of funds in my 401(k) plan?

Your first stop should be Morningstar.com. Click on the ‘funds’ tab of Morningstar’s home page and then enter your fund’s name (or five-character ticker symbol if you have it) in the search box at the upper left of the screen. You may have to enter just the fund family name and then wade through many funds to find what you are looking for.

When you get to the fund’s “snapshot” page, you’ll see its asset class listed under “Morningstar category.”

If you can’t find a fund this way, contact your plan administrator and ask for the fund ticker symbol. If there isn’t one or if the fund is a proprietary one that’s not available outside your plan, ask the plan administrator where this fund would fall in Morningstar’s nine-slot style box.

I appreciate your online resources and articles, but I want some personal advice on how I’m using my 401(k) plan. I’ve asked a couple of brokers, but they seem more interested in getting me to buy products from them. What do you suggest?

Here are three suggestions. First, see if your parents or somebody else in your family whose judgment you trust (I’m going to assume that your parents fall into that category, but it isn’t always so!) have an advisor they could recommend to you. Often a good advisor is willing to consult with family members either on an hourly basis or at no extra charge.

Second, consider hiring a certified public accountant who has a personal finance specialist designation. You’ll know you’re dealing with somebody who’s very good at numbers and finance.

Third, inquire at work and see if you can find some fellow employee who has your plan figured out. At almost every company there will be at least one person who has taken the trouble to study a 401(k) plan thoroughly. If you can find such a person, he or she probably will be happy to share this knowledge with you. You will be on your own, of course, to evaluate whether you’re dealing with a know-it-all blowhard or an intelligent, reliable person with good judgment.

I am a trustee of my company’s 401(k) plan and we are considering making some changes to improve the plan. Do you have any advice?

You bet I do! The most important thing you can do for your plan participants is to give them access to the best plan options. First and foremost this means low-cost index funds that invest in all the most important asset classes. We believe that the best mutual funds in the world are those offered by Dimensional Fund Advisors (DFA), and I hope you will contact that Santa Monica company to see if you can include their funds.

We think the ideal 401(k) plan would include these Dimensional funds: U.S. Large Company (DFLCX), U.S. Large Cap Value (DFLVX), U.S. Micro Cap (DFSCX), U.S. Small Cap Value (DFSVX), Large Cap International (DFALX), International Value (DFIVX), International Small Company (DFISX), International Small Cap Value (DFISV), Emerging Markets (DFEMX), Five-Year Global Fixed Income (DFGBX) and Two-Year Global Fixed Income (DFGFX). For more on why we think so highly of these funds, go to FundAdvice.com and read an article called ‘The best mutual funds in the world.’

Our second-favorite family of funds is Vanguard, known for its very-low-cost index funds. The choices we’d like to see there are 500 Index (VFINX), Value Index (VIVAX), Small-Cap Index (NAESX), Small-Cap Value Index (VISVX), Developed Markets Index (VDMIX), International Value (VTRIX), International Explorer (VINEX), Emerging Markets (VEIEX), Short-Term Investment Grade (VFSTX) and Total Bond Index (VBMFX). (Editor's note: International Explorer is closed to new private investors, but Vanguard could make it available to 401(k) participants.)

We know that some plan participants will want a single fund to meet all their needs, and while we don’t think any fund does that job extremely well, Vanguard Wellington (VWELX) comes closer than anything else we know of. So I’d suggest you see if you can get that one in the plan also.

Beyond offering the right fund options, I would encourage you to establish a “default” participation plan that encourages your employees to participate. New employees should be automatically registered in the plan to participate at some percentage level unless they choose a different option. And I believe you would do your employees a real service by having this default contribution percentage grow, perhaps by one percentage point per year.

I’d suggest that the default asset allocation would be 60 percent in equity funds and 40 percent in fixed-income funds. That’s a mix that will work well for most people.

I have heard I should rebalance my funds but it’s never clear when the best time is to do this.

It really doesn’t matter when you rebalance your 401(k). What matters is that you do it. Once a year is the right interval in my opinion, and it can be any time that you’ll remember. Some people like to do it during the week of their birthdays. It actually would be fine to schedule it for any time during the month of your birthday, since this doesn’t need rocket-science precision.

If you’re regularly contributing to your 401(k), as most people do while they’re working, you may be able to keep your actual asset allocation in line with your target allocation by allocating new money to asset classes in which you are underweighted. For example if your equity percentage should be 60 percent and it has grown to 70 percent, you may be able to correct that by designating most or all of your new contributions to fixed-income funds.

This is more effective in smaller accounts, when your contributions have more of an effect on percentages. If your annual contributions total $12,000 and your account is worth $40,000, the new money can make a big difference. But if your account is worth, say, $500,000, your contributions won’t change your overall allocation very much.

I’d suggest that you check your allocations twice a year and adjust new contributions as necessary. Once a year, buy and sell as needed to bring your account back to its target allocations.

I work at Boeing and just turned 60. I have learned that I can roll my 401(k) into an IRA while I still work there. Should I do this?

Yes, I think it’s a good idea. Boeing and some other companies offer this option to employees who reach age 60. The Boeing 401(k) plan is excellent, but it doesn’t offer the flexibility of an IRA. You’ll probably be able to do a more precise job of proper asset allocation with a Rollover IRA.

I just got a nice raise and I have an extra $800 a month that I want to use to improve my balance sheet. Should I increase my 401(k) contribution or use the money to pay down my mortgage balance?

Congratulations on the raise. I hope you will be sure to do something good for yourself and your family with part of it. I think you’ll probably be ahead financially to use the extra money to beef up your investments instead of paying down the mortgage. I say ‘probably’ because everybody’s situation is different.

In the absence of some unusual circumstance, I suggest you fully fund your 401(k) and your Roth IRA (and your spouse’s Roth IRA if you are married) before you chip away at the mortgage. Your investments probably will earn a significantly higher rate of return than the interest you are paying on the mortgage. And if you are still working and able to handle the mortgage payment, then I think the cost of the loan is a legitimate living expense to come from your regular pay.

If you have fully funded your 401(k) and Roth IRAs and have an ample emergency reserve fund, you could then consider using extra money to reduce the principal on your mortgage. But remember that extra principal payments are the equivalent of an illiquid fixed-rate investment. The only way you can get that money back is expensive and inconvenient: you’ll have to refinance your loan or sell your home.

I just found out that my employer will let me fold my IRA into my 401(k) plan with the same options. Is this a good idea, to keep everything simple and under one roof?

No, it’s not a good idea. The only exception I can think of would be the unlikely case in which you have superb 401(k) investment options that you can’t get elsewhere. One of the strongest advantages of an IRA over a 401(k) is the flexibility to invest in asset classes you can’t get in a 401(k). I say keep the IRA so you maintain that flexibility to make your money work hard for you.

My plan offers the Vanguard Total Stock Market Index Fund, and this seems like a good way to get the whole works in one simple package. Should I do this?

This is not what we would recommend. While the Total Stock Market Index Fund won’t hurt you, it won’t make your money work very hard for you. Overwhelmingly, the returns you get will come from the assets in which you invest. Proper diversification requires that you include significant exposure to small-cap stocks, value stocks and international stocks. The Total Stock Market Fund has a smattering of small-cap and value exposure, but it’s primarily a large-cap growth fund. We expect that asset class to have relatively low long-term performance. You will almost certainly receive a higher long-term return, at lower risk, if you diversify according to our recommendations.

My plan offers more than 100 investment options, and there are more than a dozen funds in some asset classes. How do I choose the best funds?

First, look for index funds. Second, look for funds with low expenses. Third, you should favor funds with lower portfolio turnover. Fourth, you should look for broad-based funds that own many stocks instead of concentrated funds that own relatively few stocks.

Finally, look for funds with portfolio that are concentrated in their asset classes instead of ones that invest all over the style-book map. At Morningstar.com, the Snapshot view of a fund identifies an “ownership zone,” a shaded area that represents 75 percent of the fund’s domestic stock holdings. A wider shaded area indicates the fund owns more types of stocks. A smaller shaded area indicates a more focused portfolio.

For example, compare the “ownership zones” of Vanguard 500 Index (VFINX) and Mairs & Power Growth Fund (MPGFX). These are both large-cap blend funds, but the index fund has very little overlap into mid-cap territory and none into the small-cap realm. It is much more focused than the Mairs & Power fund, which holds a portfolio that includes every one of the nine style boxes.

You recommend index funds, but except for an Standard & Poor's 500 Index fund my plan doesn’t have index funds. What should I do?

In asset classes for which you must use actively managed funds, it’s often a good idea to have two funds for each asset class. This gives you some protection against “manager risk,” the chance that a lousy stock-picking or a series of poor choices could torpedo your investments. Use the same criteria for choosing these funds: low expenses, low portfolio turnover and portfolios made up of many stocks.

For specific 401(k) plan recommendations, visit http://www.401khelp.com/.

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