Employer saving plans like a 401(k) or a 403(b) are becoming the single largest source of retirement savings for most American workers. According to the Society of Professional Administrators and Recordkeepers (SPARK), over 55 million people participate in 401(k) plans. If you participate in a 401(k) or a 403(b) plan, the good news is that you have more control over your retirement money. The bad news is that you have more control over your retirement money.
For people who do not have the time or the financial knowledge, properly managing your retirement plan can be a daunting task. Moreover, if you do not manage it properly, the retirement plan can become, at best, a savings account and, at worst, a high-risk gamble with your retirement money.
AGH recommends 10 steps that have helped thousands of employees succeed with their retirement plan. If you lack the time or inclination to manage your own account, they will actively manage it for you. However, if you are the do-it-yourself type, these 10 steps will help.
Participate to get the benefits
The dollars in your retirement plan may represent 20-80% of your income at retirement. The government, and by extension, your employer, are giving you the opportunity to take advantage of two very powerful financial concepts: the ability to save money on a pre-tax basis, and the tax-deferred, compounded growth of those dollars. A 401(k) or 403(b) may enable you to build a better nest egg than anything else you can do on your own because of that tax-deferred growth. Saving money before it is included in your taxable income reduces your annual tax bill. In addition, the earnings can grow on a tax-deferred basis, meaning you can earn money on your earnings! If your company offers a 401(k) or 403(b) plan, you need to be contributing, as soon as you can, and as much as you can. It is the first step in taking charge of your financial future.
To help you increase the size of your nest egg, as well as to encourage reluctant employees to save for retirement, many employers offer matching funds. The average employer offers a match of 50% of the amount you contribute up to 6% of your eligible salary. In the complex world of finance, we call this free money. If your employer is willing to give you money, you need to take it!
The only catch is that you must contribute some of your own money to receive the company match. If your employer matches up to 6%, you should be contributing at least 6%. The goal is to capture the entire company match (and then keep working there until you’re fully vested).
Determine your investor profile
Investor, know thyself! Every investor is different and knowing yourself is the first step to allocating your investments appropriately. Before you can determine your asset allocation strategy, you must first be able to clearly define your goals. Remember, 401(k) and 403(b) money is retirement money and everybody has different dreams about what their retirement will entail – traveling, boating, etc. Also, you may have some pre-retirement goals for which you need to save some money. Each goal may represent a separate pool of money and there are different investment options available to you to help fund each goal.
Second, determine the time horizon for retirement. Is it more than 10 years away? In general, the longer you have until you need the money, the more heavily weighted you should be in stocks. You’ll have more time to recover any losses incurred during a market downturn. The third consideration concerns how psychologically comfortable you are with those market downturns. Will you really be able to tolerate the inevitable ups and downs that the stock market delivers?
Allocate your money appropriately
Asset allocation is the principle of deciding how to spread your investments across various asset classes, such as stocks, bonds, and cash. There are subcategories within each class, such as small, medium and large cap stocks. The idea is to diversify your holdings to potentially increase returns while diminishing risk. A variety of factors determines the appropriate allocation for each individual:
- When you need the money (not automatically dictated by your retirement age)
- How much money you have now and expect to need later
- What kind of risks you’re willing to take
- Other assets you have invested outside of your retirement account
- Perhaps the most important factor is your time horizon – the more time you have, the more aggressive you can be
Limit exposure to company stock
Company stock can be a double-edged sword. On one hand, as a loyal employee who understands the business, you want to participate in the growth of the company by being a shareholder. On the other hand, it is risky to have too much of your portfolio in one stock. Having too much money in a single stock issue creates a non-diversified portfolio. Most investors can reduce volatility significantly by having a diversified portfolio. Besides, do you really want the fortunes of one company to control your salary, benefits, pension and your 401(k)?
Don’t forget to rebalance your portfolio
While it is not advisable to move your money around daily (market timing in general has not proven to be an effective strategy over the long haul), it is advisable to look at what your investments are doing from time to time. If one segment of the market has outperformed other segments significantly, then your portfolio is likely to be significantly out of balance. In other words, if you wanted to have 70% of your money in stocks, and it has grown to represent 80% of your portfolio, you need to rebalance your portfolio. You may also need to consider other strategic moves if your mutual fund suffers from style drift, there’s a change in management, or if a similar fund with lower expenses becomes available. Take a disciplined approach to monitoring your investment portfolio.
Do not panic
Listening to the evening news, and hearing about the daily market changes, can cause even the most stalwart of investors to get nervous. Stocks fluctuate in value, it’s the nature of the beast. Just remember that you are investing in your retirement account for the long term. Although there are no guarantees that this will continue in the future, the direction of the stock market over the long term has been up. There will continue to be downward dips and swings, which is why knowing how you’ll react to those swings is a factor to consider in your overall asset allocation. Selling when your investments are down is the best way to lock in your losses. Try to remember that patience is a virtue. Unless you believe that the investment cannot recover, it is usually better to hold on for the ride. In fact, it might be a good opportunity to buy more!
Know your plan features
Every retirement plan has unique characteristics. To help maximize your plan, you need to know all your options. Your plan’s Summary Plan Description document, distributed by your benefits department, will outline options such hardship withdrawals, loans, vesting schedule, limitations to moving money, and in-service withdrawals. Read this document carefully or have a financial professional review it with you.
Some plans allow for hardship withdrawals. There are several tax and penalty issues associated with hardship withdrawals, so make sure you read your plan’s Summary Plan Description carefully and seek professional guidance.
The vesting schedule refers to the years of employment before the company match or other employer contributed money such as profit sharing becomes yours. Vesting schedules either are graded, meaning you get a percentage of the money in successive years of employment; or cliff, meaning you get all the money at once after no more than five years. Keep the vesting schedule in mind if you are thinking about quitting your job.
Borrow wisely – if at all
Early retirement plans had no provision for loans. Providers added most loan provisions as an incentive to encourage greater participation – participants would be more likely to save for retirement if they could access the money before they retired. This does not make loans an attractive feature! Many people believe (often erroneously) that if the interest rate on the 401(k) loan is less than they would have to pay elsewhere, the 401(k) loan is a good deal. That may be, but it does not take into consideration the real cost of the loan – the lost opportunity cost.
The money in your plan cannot grow if it is not there! If the investments in your plan are growing by 12%, that is what borrowing from the plan costs you, plus growth on that growth. Another consideration needs to be the tax consequences of borrowing from your plan. While you do not pay any taxes on the money when you borrow it, you do pay the loan back with after-tax dollars. Then, when you begin to take withdrawals at retirement, you pay taxes on those dollars again – you are paying taxes twice. If you do some calculations, you may find that borrowing from your plan is an extremely expensive option. Borrow only if you must.
Consider tax consequences of your actions
Most of the things we do in our financial lives have tax consequences. In the case of the 401(k) and 403(b) plans, you can avoid several negative tax consequences. If you leave your current employer and want to take your retirement money with you, be sure to roll it over directly to an IRA or to another employer’s plan. You may leave it in your former employer's plan if you have more than $5,000 in your account. If you take a full distribution and do not rollover your balance into an IRA or into your next employer’s plan, you will pay federal and state taxes on the entire amount. If you are not yet 59 ½, you will also pay a 10% penalty. This could reduce your lump sum distribution to almost half its original value. It will not help your retirement nest egg.
Do not take a lump sum at retirement unless you need all the money at once. Take out only what you need, so the bulk of the portfolio can continue to grow tax-deferred. If you are over 72, you must follow the Required Minimum Distribution rules. Rolling your money from your retirement plan to an IRA may make sense for a variety of reasons, and fortunately, an IRA rollover is not a taxable event.
At retirement, balance your needs for income and growth
Most people should disregard the notion that when you retire you should move all your money into bonds and stay clear of the stock market. Inflation, even when it is under control, has a nasty way of ensuring that a dollar in the future will not buy what a dollar does today. You must ensure that your investment holdings have the potential to outpace inflation, so that the income you receive from your investments can have the same purchasing power when you’re 85 as it does when you’re 65. This means you should have a portion of your money in investments that have the potential to outpace inflation, such as stocks, regardless of your age.