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For many American investors – perhaps the majority – the 401(k) plan (and its near-clones for non-profit organizations) has become the mainstay of retirement savings. It’s not hard to see why. These plans combine tax advantages with automatic savings and in many cases the incentive of matching funds from employers. Editor's note: This article, first published in 2002, was updated in October 2007.
But for various reasons, many workers don’t get all that they could from their plans. Managing these investments may seem like a daunting task, and it does require some study and diligence. But the payoff can be enormous, for those who are willing to do the work.
Lots of people spend at least a dozen hours studying and shopping for a new vehicle. Many more have no hesitation spending a dozen hours planning a vacation. So I often wonder why so many people won’t spend the same amount of time planning for their retirement.
You work (or worked) hard for every dollar you put into a 401(k) plan, and you have a right to expect each of those dollars to work hard for you. But you are the one who has to make that happen.
Here’s my promise: If you’ll spend a dozen hours learning about and managing your 401(k), you’re ultimate payoff will be much greater than you will get from any vehicle or any vacation. This is true whether you’re 30 years away from retirement or already retired.
Following the 12 suggestions in this article should take you less than 12 hours. Over a lifetime, the payoff could put an extra $2 million in your retirement fund. Even if it takes you 100 hours to follow these steps, that’s a payoff of $20,000 an hour. If you can make that much money some other way, at home in your spare time, you don’t need this article. In fact, I hope you’ll tell me how you do it!
So let’s get right to my 12 guidelines. The first one is the most basic of all.
Step 1: Be a participant. It’s that simple: If you don’t participate, you will never get any benefit from your plan. First and foremost, you should contribute as much as you can afford. At the very least, this should be enough to qualify for any matching dollars you might get from your employer. I’m always amazed at people who pass up the opportunity to get matching contributions. They are essentially passing up free money.
The way to participate effectively is through automatic investments from your paycheck. This gives you a classic “pay yourself first” strategy. If you can’t afford to contribute the entire amount your plan allows, do as much as you can. Then, next time you get a raise, earmark at least half of it to increase your 401(k) contributions.
Step 2: Invest in the right things. This can be challenging depending on the options in your plan. But in importance, it’s second only to Step 1.
The general principal is to diversify your investments widely so you don’t put very many of your eggs in any single basket. This means dividing your portfolio among stocks, bonds and cash. More important, it means dividing your equity investments among all the major equity asset classes.
We have written extensively on this in the past, and there’s room here for only a brief overview. The easiest and most comfortable way for most people to invest is in funds that own stocks of large, familiar companies with solid growth rates. General Electric, Microsoft and Pfizer are three of the most prominent examples. These are called large-cap growth stocks because they represent large companies.
In the late 1990s, these stocks soared, unfortunately convincing many investors they needed to look no further in order to amass wealth. But starting in 2000, most of these stocks stumbled badly.
In addition to large-cap stocks such as those in the Standard & Poor's 500 Index, your long-term investments should include funds that focus their portfolios in large-cap value stocks, small-cap stocks and small-cap value stocks. We recommend that half of your long-term equity holdings be made up of international stock funds, ideally divided five ways: international large-cap stocks, international large-cap value stocks, international small-cap stocks, international small-cap value stocks and stocks of emerging markets.
Very few 401(k) plans have all those options, and you’ll have to come as close as you can with what’s in the plan. (See Step 11 below.)
When you can choose among multiple options focusing on a single asset class, look for funds with the lowest expense ratios. These will often be index funds – and they make excellent choices.
Step 3: Know what your needs are. This is actually a prerequisite to Step 2, because it will tell you how much to have in stock funds, how much to have in bond funds and how much (if anything) to keep in money-market funds or the equivalent.
There’s no reliable rule of thumb to figure out how much to invest in bonds and how much in stocks. Over long periods of time, stocks have always had higher returns than bonds. But in many shorter periods (such as 2000 through 2002), bonds have outperformed stocks.
Here’s a quick-and-dirty rule of thumb that will at least put you in the ballpark of an appropriate stocks/bonds allocation: Subtract your age from 110, and use that as the percentage of your portfolio that ought to be in stock funds. The rest should be in bond funds. Example: If you’re 40 years old, you’d be 70 percent in stock funds and 30 percent in bond funds.
This rule is less accurate for younger investors. There isn’t a great need for a 25-year-old, for example, to keep 15 percent of his or her retirement savings in bond funds. When you’re in your 20s, you need growth and you have lots of time to weather the storms of the stock market.
Here’s a fundamental principle that is too little understood: Investors always have more control over what they might lose than over what they might make. And as imperfect as this allocation rule is, it forces you to focus on what you can control: how much you might lose. By gradually adding bond funds as you grow older, you gradually decrease your relative exposure to the risk of loss.
I’ve never heard anybody complain about losing too much money because he invested with moderation.
Step 4: Don’t invest your retirement plan assets in stock of the company you work for. I hope the experience of employees at companies like Enron, Polaroid, Tyco and WorldCom have made it obvious that it’s dumb to load up a 401(k) plan with company stock.
A retirement plan is supposed to give you security. You don’t get security from doubling your bets. You get security from spreading your bets around. To continue the betting analogy, you are already relying on your employer for your livelihood. Unless you are a multi-millionaire, your greatest resource and asset is most likely your ability to earn a living. Your employer is a key part of that.
Even if you essentially own the company, no job is ever 100 percent secure. You are betting heavily on being able to continue that job (or getting another one, which often becomes harder and harder the older you get). Layoffs and corporate takeovers can happen to any company, without warning.
So can stock implosions. As we saw with Enron in 2002, even the world’s most admired corporations can quickly fall out of favor with investors.
Putting the bulk of your retirement money in stock of any one company is a very risky proposition. And when you’re already relying on the same company for your income, it’s just plain foolish.
Think of it this way: Do you want your income, your benefits, your pension and your 401(k) all to depend on the unpredictable fortunes of just one company? I hope not!
Step 5: Don’t borrow against your 401(k) savings; keep them for retirement. Unfortunately, many 401(k) plans allow employees to borrow against their savings. The rationale is that workers will be more likely to participate (see Step 1 above) if they can have access to their money before they retire. In my opinion, this is a bad idea.
It should go without saying that money you borrow from your retirement plan can’t be working for you as it should be. But it’s worse than that.
In most 401(k) plans, you can borrow money only for specific “hardship” purposes. This does not include making a down payment on a vacation home. Even when you qualify for a 401(k) loan, IRS rules make this a poor choice.
For one example, if for any reason you cease to be an employee at your company, the entire balance of the loan becomes due and payable immediately. If you don’t pay, you will have to pay taxes (plus a 10 percent penalty if you are under 59 ½ years old) on the loan balance. This means that if you are laid off, you will suddenly have to pay back this loan – just at the time you may be the least able to afford it.
For a second example, you must pay interest on the loan you take out. So far, so good, and the interest is paid to your own account, thus increasing the assets in the account. However, there’s a hitch: Not many people understand this, but you will pay taxes twice on the interest you pay on a 401(k) loan. You’ll pay taxes the first time on the income you earn in order to pay the interest. And when you take the money out of your plan at retirement, you’ll be taxed on it once again.
Step 6: Rebalance your investments once a year. This is pretty simple, and it might take you all of 30 minutes each year. Your overall plan for your 401(k) account should be stated in percentages. So much in bonds, so much in stocks. So much in large cap stocks, so much in small-cap; so much in growth stocks, so much in value; so much in U.S. stocks, so much in international.
Each one of these asset classes will move up and down at different times and different speeds. Periodically you should rebalance each one to bring everything back into alignment.
You can do this more often, but once a year is enough to give you the benefits. The steps are simple: Write down the total in your plan, then apply your allocation percentages (which you should have in writing in a notebook or in a handy file in your computer) to that total. Some funds will have too much, and you should sell enough of them to bring them into line. Use the proceeds from those sales to buy more of the funds that are under-represented.
You may not always feel like doing this. At the end of 1999, you might have had a large-cap growth stock allocation that seemed to be making your investment dreams come true. It might have been uncomfortable to sell some of what had been doing so well and put the money into something else that had been under-performing.
But in hindsight, millions of 401(k) investors wish they had trimmed their growth stocks at the end of 1999. If they had followed this guideline, they would be in better financial shape now.
Most people say they want to buy low and sell high. Rebalancing your assets once a year forces you to do that, whether or not it feels good. If you don’t do this, some assets will grow to make up much more of your portfolio than you had planned. That increases your risk.
My advice: Follow this as a mechanical discipline, whether or not it seems like a good idea at the time. And be patient. Patience is a great virtue that’s too often overlooked in our fast-paced society. When you’re managing your life’s savings, put patience on your team. You won’t be sorry.
Step 7: Know your plan. Reading your plan literature and studying your investment options won’t be the most exciting couple of hours you’ll ever spend. But it will be well worth your time. You’ll learn how you can invest in the right things (see Step 2 above). You’ll learn what provisions there are, if any, for loans (see Step 5 above). You’ll know your rights and what conditions, if any, must be met in order to get matching funds and to make sure that you won’t have to give that “free money” back to your employer. (This is called vesting, and you’d better be sure you understand this before you quit your job for greener pastures.) You’ll find out what restrictions, if any, the plan puts on moving money around from one option to the other (see Step 6 above).
Ideally, retirement plan documents are written in plain English so they are easy to understand. In the real world, they are often written by lawyers who are paid to protect the interests of the plan’s sponsors, not its participants. Give the documents a once-through read, and use a colored highlighter to mark places where you’re unsure of the meaning. Ask somebody at your place of work to explain those provisions to you.
Step 8: Be careful of tax traps. Everything you do in your 401(k) plan will be reported to the Internal Revenue Service, and all of it has some tax consequences. One of the biggest tax traps lies in wait to snare 401(k) participants who leave their jobs, either voluntarily or involuntarily. When you part company with your employer, you are entitled to cash in your 401(k) assets and take the money with you. You can then do whatever you want with it.
But just because something is allowed doesn’t make it a good idea. Taking your 401(k) assets in cash in order to postpone getting a new job is a poor idea. When you remove money from your plan, you’ll give up your hard-earned savings and the money you could make from them. Also, you’ll have to pay tax on what you take out – plus a 10 percent penalty if you are under age 59½. That means that if you’re in the 25 percent tax bracket, you might get to keep only 65 cents of every 401(k) dollar you withdraw.
When you leave your job, the smart thing to do is either leave the money where it is, in your employer’s 401(k) or put it in a Rollover IRA. The Rollover IRA will give you virtually unlimited investment options so you can do a better job of getting the best possible allocation of your assets (see Step 2 above).
Now here’s the trap: The IRS gives you two ways to move the money into that Rollover IRA. The right way is in a direct transfer of funds from your 401(k) custodian directly to your IRA custodian. This way you never take possession of the money, and there’s no tax bite on this transaction.
The wrong way is to have your employer cut you a check, on the understanding that you’ll deposit the money yourself into a new Rollover IRA. If you do this, you’ll wish you hadn’t. The IRS requires your employer to withhold (just like tax withholding from your paychecks) 20 percent of any 401(k) proceeds you take in cash at the termination of your employment. If you put the money into the Rollover IRA within 60 days, you won’t be taxed on it. But here’s the rub: Any of the 401(k) money that you don’t put into the new IRA within 60 days will be treated as a taxable withdrawal, possibly also subject to the 10 percent penalty – and this includes the 20 percent that you were required to pay the IRS.
Example: If you have $60,000 in your IRA when you leave your job and ask for the money in cash, the employer pays $12,000 to the IRS and gives you a check for $48,000. You can invest that $48,000 into a Rollover IRA, without tax consequences. But unless you also invest another $12,000, the IRS will tax you (and possibly also penalize you 10 percent) on the $12,000 that you had withheld. It doesn’t seem right or fair, but that’s the law.
Step 9: Make a new financial plan when you retire. If you’ve done your homework up to this point (see especially Steps 2 and 3 above), you won’t find this too hard. But take this very seriously. Retirement is a big deal, and in some ways the rules of your financial life will change in a big way when you stop working and start living off of your savings.
If you’ve followed prudent asset allocation, you have probably decreased your exposure to risk gradually as you get closer to retirement age. But you need to revisit that topic when you retire. When your portfolio starts paying you, it in a sense takes the place of your employer. Just as you must treat your employer with care and respect, you need to treat your portfolio well, too. When you were employed, unless you owned the company, you couldn’t simply give yourself a raise or a bonus whenever you wanted one. But when your income comes from a pool of money that you control, you can in effect give yourself a raise or a bonus whenever you want. Don’t do it!
Use a disciplined approach to setting the amount you withdraw, set the amount (or formula for determining the amount) very carefully, then stick to that discipline.
Some basic rules of investing also change when you retire. While you’re accumulating money for retirement, the biggest risk you face is either not saving enough or losing too much of it in the market after you invest. Your “punishment” could be that you have to work longer before you retire. That is a disappointing outcome, but it’s usually not an insurmountable hurdle.
But when you’re living off your retirement savings, your biggest risk is eventually running out of money. When that happens, your options are much bleaker. To avoid running out of money, you need to pay attention to three key things: the amount you withdraw each year (which is largely under your control), the return you get on your investments (only indirectly under your control) and the extent to which you expose your portfolio to the risk of market losses (which is generally under your control).
Bottom line advice: Give this turning point in your life a lot of careful thought at the start. If you have any question about whether you are doing the right thing, get help from a financial professional who does not sell products.
Step 10: If your plan allows it, roll your 401(k) over into an IRA once you reach the age of 59 ½, even if you are still working. If you have that option, take it. There won’t be any tax consequence to this move, and you’ll gain a lot more flexibility in your investment options (see Step 2 above).
We have helped many workers at Boeing make this move with money they have accumulated by age 59 ½ (though their new contributions continue to go into Boeing’s plan). Most company retirement plans, including Boeing’s, give workers inadequate choices for investing in small-cap stocks, value stocks and international stocks, each of which is a very good way to reduce the risks of investing in stock funds. (see Step 11 next).
Step 11: Lobby the trustees of your plan for better investment options. If you and enough of your fellow employees all make your wishes known, you may be able to persuade the trustees to add some options, most likely including funds that invest in small-cap stocks, value stocks and international stocks.
To do this successfully requires that you know who makes the decisions (see Step 7 above) about your plan. And it requires you to understand what you want and why it is to your benefit and the benefit of your fellow employees (see Step 2 above).
Don’t forget, the trustees of your plan are likely to be executives or officers of your company – and that they probably have their own money in the same plan. Remember that it is also in their best interests to have a plan with better options. When you contact them, give them copies of an article you can download from our Web site. It’s called “The Ultimate Buy and Hold Strategy.”
Step 12: Consider giving your children the money each year so they can maximize their 401(k) contributions. This one is for parents with grown sons or daughters who are working and participating in 401(k) plans. That may seem like strange advice, and of course it won’t apply to everyone. But I hope you’ll consider this before you dismiss the idea.
If you have money you won’t need for yourself, money you’re planning to leave to your kids, you may get much more “bang for the buck” by giving some of it to them while you’re alive.
Let’s look first at the benefits to you. You can make a gift of $12,000 a year to any person free of gift tax. By doing so, you avoid ever having to pay estate tax on that $12,000. This is a tried-and-true estate planning technique, a way to put more of your money in the hands of your heirs and less in the hands of the IRS.
This also gives you an opening to interact seriously with your offspring about investing. If you are giving your daughter $12,000 for her 401(k) plan, you can be pretty sure you’ll have her full and complete attention! If you can use this opportunity to teach her how to make the most of her 401(k) plan (see Steps 1-11 above), you’ll be doing her one of the biggest favors a parent can do.
Naturally, most of the benefits of this will accrue to your daughter (or son, but we’ll use daughter for this example).
The mechanics of making this gift is that your daughter contributes the maximum to her plan, which might conveniently be $12,000. You in turn reimburse her regularly (perhaps once a month) for the income she diverted into her savings plan.
The first benefit to her is a tax deduction. The second is any matching money that her employer kicks in. The third is the opportunity to fully save for her retirement without giving up her income. Particularly in her early working years, she is likely to need all her income for living expenses; it’s also the time when retirement savings can do the most good, because they have the most years in order to compound.
Obviously, leaving her $12,000 a year will reduce what you can leave her at your death. But even if you didn’t leave her a dime in your will, the effect of your gifts could be worth millions to her when she retires.
If you gave her $12,000 a year for 30 years while she worked, the total cost (in constant dollars) to you would be $360,000 – and of course you wouldn’t give it all at once. If she earned 10 percent on that money, after 30 years it could grow to nearly $2 million. If you did this for 35 years, it would grow to $3.2 million. And that doesn’t count any matching money from her employer.
Every working person eligible for a 401(k) plan can follow the first 11 guidelines. And if you are fortunate enough to be able to follow the 12th one, it’s a great way to give your heirs not only money but your investment wisdom as well.
These 12 guidelines may or may not make you wealthy. But they will certainly make you a better investor. Whether they save you from even a small loss or earn you an extra $2 million over a lifetime, the time you spend on this could be the most lucrative in your financial life.
You’ll put yourself in control of all the major things that you can control. And you’ll give yourself the best chances for achieving “a piece of the action along with peace of mind.”
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