All About 401(k) Plans

Last edited Thu Feb 14, 2013, 06:55 PM - Edit history (1)

Well, that's too presumptuous. This isn't EVERYTHING about 401(k)s and other retirement plans. But hopefully, it's a start. (I wrote it a few years ago, so forgive me for not updating some things.)

Not everyone has a company retirement plan at work in which they can participate. But many people do; yet they don’t contribute. Others participate, but don’t contribute enough. I don’t understand why not.

Quite often, I think the problem is that many workers have never been fully informed about the benefits and advantages of saving and investing through the company plan. Oftentimes, that is the fault of the employer, who should make sure the employees understand their retirement plan choices.

Oftentimes, it’s also the fault of the 401(k) provider, who may be a mutual fund company, an insurance company, or a brokerage firm. Someone from that company should be available to participants at least once a year, for consultations. You should be able to have a one-on-one, sit-down, face-to-face meeting with an impartial adviser who will review your retirement investment choices, your beneficiary designations, your retirement goals, etc. You should be able to ask straight questions and get simple, accurate answers.

Unfortunately, that doesn't happen very often. In my experience, very few companies with plans offer this kind of service. This thread should give you some of the answers you’re not getting at work.


Why should I use my employer’s retirement plan?

Most retirement plans share certain characteristics, whether your plan at work is a 401(k), a 403(b), or a SIMPLE IRA. And there are some good, compelling reasons to participate in the plan and start investing for your retirement:

Convenience. The first main advantage of saving or investing through an employer-sponsored retirement plan is the convenience of contributing through payroll deduction. We all know we should be saving for our retirement, but if it’s completely up to us to do so, we wouldn’t do anything. Be honest. If you don’t put money in your company plan, when are you ever going to save? You will spend that money on something. I know I would. There are all sorts of people out there that want to get their hands on my money; and there’s no shortage of toys and gizmos on which I’d like to blow my hard-earned dollars.

By signing up for the company retirement plan, you eliminate this temptation. You wind up paying yourself—your retired self—first. Usually, signing up is no more difficult than filling out a form saying what percentage of your paycheck you’d like to put in the plan, and how you’d like that money invested. Once you sign up (assuming you are eligible to get into your employer’s plan; you may have to ask to make sure), that percentage you wanted to contribute will AUTOMATICALLY be deducted from your check and put into the investments you have chosen. You don’t have to remember to save; you’re doing so automatically. Auto-pilot is a beautiful thing.

Once you sign up to automatically deduct your retirement contribution from your paycheck, pretty soon, you won’t even miss it. And that’s what you want to have happen. It’s much easier to keep doing something if it’s painless.

Tax benefits.The other huge benefit that these retirement plans give us is the opportunity to reduce the taxes we’re paying today, and defer taxes on your whole retirement plan for several years—perhaps decades! Here’s the deal: The percentage of your pay that you designate to go into your retirement plan comes from your gross paycheck. In other words, you don’t pay income taxes on the part of your paycheck that you put into your pretax retirement fund. Well, you don’t pay it now…you will later. Hopefully, much later—when you retire. Thus, this reduces the amount of your paycheck that is subject to income taxes. (The Roth 401k and 403b are treated very differently, and we will discuss those later.)

As you invest your money in stocks and bonds, and as it grows over the years, you don’t pay taxes on the growth you see in your account. As long as these assets stay within the plan, they are tax-deferred. You won’t pay income taxes on your retirement plan money until you pull it out of the plan. That means you may be able to enjoy decades of tax-deferred growth. If you invested in a regular, taxable account, you might have to pay taxes each and every year on your investment earnings. Inside your retirement plan, your money grows and compounds more quickly, because you don’t have to send part of it to Washington every year.

Variety and growth potential. Most company retirement plans have plenty of investments to choose from. Actually, many plans offer too many choices. With a bit of research and knowledge, you should be able to piece together the right portfolio to fit your needs, your time horizon, and your risk tolerance. Your plan should—and probably does—offer funds that invest in growth stocks, value stocks, big company stocks, small company stocks, international stocks, and bonds. If you diversify and choose some decent funds, you should have no problem staying ahead of inflation in the long run. That’s how you grow your wealth.

Company match. Your employer may be willing to help you as you are saving for your retirement, by contributing to your account. This obviously accelerates your retirement savings, and is basically like receiving a raise in pay, just for participating in the plan. Not all companies match their employees’ contributions, though, so you should find out if yours does.


What types of investment choices are in my plan?

Every retirement plan is different and offers different investment choices to participants. Here’s a quick run-down on the types of funds you’ll likely see in your plan:

Large Cap Index Fund. This is a fund that invests in the stocks of very large corporations (hence, “large cap” or capitalization) that are included in a Stock Index, an arbitrary basket of a certain number of companies. The most common index used is the Standard and Poor’s 500 index, usually called the S&P 500. This index tracks the stock prices of the 500 largest companies in the U.S. stock market. Generally speaking, if the overall market is doing well, this fund will, too. If the overall stock market is doing badly, this fund will, too.

Large Cap Growth Fund. Again, this fund invests in big companies, but they tend to be fast-growing companies that take their earnings and plow them right back into the company—more research and development for new products and innovations, expanding into new markets, etc. Dividends are not common among growth companies. What the fund manager hopes is that the stock price will go up from the time the stock is added to the fund portfolio, so it can be sold at a profit. Growth stocks tend to go up right along with the market—or even faster—when the market is in an extended upswing, but tend to go down as fast as—or faster—than the market in a downturn.

Large Cap Value Fund. This fund generally invests in large companies whose stocks may be on sale at the time of purchase. This is often called a Growth and Income Fund, mainly to point out the potential for both capital appreciation and dividend income. Older, more established companies sometimes share their earnings with their shareholders in the dorm of dividends, usually paid quarterly or semi-annually. Sometimes also called an Equity Income Fund.

Mid Cap Fund. This fund invests in medium-sized companies—not too big, not too small. These stocks are much more volatile than large caps, but not quite as bouncy as small caps. Mid Cap funds can have either a growth bent or a value bent.

Small Cap Fund. This fund may be either growth- or value-oriented, but it invests primarily in smaller companies. Smaller companies are usually newer companies, and there’s a much higher risk that they may go out of business. The price of these smaller stocks can be very volatile—it can drop sharply on bad news, but it can also rise quickly on good news. Sometimes called Aggressive Growth Fund.

Bond Fund. As the name implies, rather than investing in stocks, this fund invests in bonds, usually corporate bonds. Bonds tend to have less volatility than stocks, but this type of fund still can lose value, especially when interest rates are on the rise. Bond funds tend to be a good complement to stock funds, as bonds often do well when stocks are doing poorly.

Balanced Fund. This fund invests in a mixture of stocks and bonds, usually keeping to a certain percentage in each.

Sector Fund. Your plan might have a sector fund or two. This is a fund that invests almost exclusively in one industry or one sector of the economy. For example, you may have a Real Estate sector fund, or a Health Care fund, or even a Technology or Utilities sector fund. These funds are much riskier than the more broadly diversified fund. If that one sector that the fund invests in falls out of favor with the market, that fund will drop sharply. But if you feel very strongly that a particular industry is poised for significant growth over the next year or two, you may want to allocate a small percentage of your contributions to the corresponding fund.

Your plan may offer more types of funds than these. It’s very possible that your plan does not offer all these categories. Make do with what you have and create the best portfolio you can.

Briefly, you should probably have a healthy mix of at least a few of these different types of investments. Don’t invest just in one category.


When should I withdraw money from my retirement plan?

When will you pull the money out of your retirement plan? At retirement, of course. You do not want to touch this money until you have reached retirement age, which, as far as the government is concerned, is age 59 ½. Let’s round it up to age 60, because that’s easier to remember. Leave the money in your plan until age 60, and your earnings get to grow and grow and grow, tax-deferred, all those years and decades. Your money will compound much faster than if it were in a taxable account, because you don’t have to pay taxes each year on your gains.

If you touch your money before retirement age—before age 59 ½—you will probably have to pay a hefty penalty to the government on top of your regular taxes. Not only will you have to pay taxes on your 401(k) or IRA and pay taxes at your ordinary income tax rate, but you will also have to pay the IRA an extra 10% penalty, because you’re trying to pull money out of your retirement plan before you reach retirement age.

Here’s how it would work. Let’s say you have $10,000 saved up in your 401(k) plan, and you switch jobs. You decide to just pull out the ten grand and use it for moving expenses, maybe for a down payment on a house, or something like that. Let’s assume that you’re in a 30% combined federal and state tax bracket. And let’s assume you are younger than 59 ½ years of age. How much money will you actually get?

Total account value before withdrawal $10,000
Minus 30% income taxes -$3,000
Subtotal $7,000
Minus extra 10% penalty -$1,000
End result $6,000

Ouch! You just lost 40% of your retirement savings and gave it to the government. Why would you want to give them nearly half of what you’ve been saving up for so long?

That extra 10% is very painful. 10% may not sound like much, but it hurts on top of the regular taxes. Keep in mind the 10% penalty is on the entire account value at the time you withdraw the money. It’s not a 10% penalty on what’s left over after you pay your regular taxes—which would be nice, since that would be much less. But it’s a penalty on the whole enchilada.

Don’t do it! If you withdraw all your retirement savings and spend them—on a house, on a car, on a boat, on anything—then you are back to zero. You are now forced to start over with your retirement savings—and now you’re closer to retirement! You have less time to play catch-up! I have seen too many people attempt to win this game. They all lost.
Leave your retirement money in your retirement plan until you reach retirement age.


I don’t trust 401(k) plans. Look what happened at Enron.

This was a fairly common objection a few years back when Enron was in the headlines every day, and I still hear it from time to time.
For those who don’t remember, Enron was a large energy trading company based in Houston that, due to lousy accounting and unscrupulous dealings, went belly up in 2001. The once-mighty firm, which was the fifth-largest U.S. corporation at its peak, plunged into bankruptcy, its stock becoming virtually worthless almost overnight, when its dirty dealings were made public.

Enron’s 11,000 employees lost an estimated $1 Billion that they had invested in their 401(k) plan. Many dreams of early retirement were instantly dashed as those nest eggs were pulverized in the aftermath of the scandal.

Many people have since asked me, “Why should I put money in my company’s 401(k) plan? I don’t want to end up broke like those Enron employees.”

I understand the fear. But there is no reason for it. Yes, let’s look at the Enron debacle and consider a few facts:

Enron employees were heavily—in many cases, exclusively—invested in only one investment: their employer’s stock. Enron encouraged employees to invest heavily in Enron stock, hoping to drive the stock price even higher. When all you invest in is the stock of one company, and that company goes bankrupt, your investment is worthless. If you bought the stock at $30 or $40 or $80 a share, and suddenly it drops down to almost zero, you have effectively lost all your money.

Enron employees could have invested in 18 other investment options in their 401(k) plan. Most of these options were mutual funds which have had handsome returns since 2001. If Enron employees had invested in some of these funds, not only would they not be broke today, they would actually be wealthier than they were in 2001.

Yes, even though their company went bankrupt, their 401(k) wouldn't have, had it been invested in prudently diversified funds. Just because an employer goes belly up doesn't mean the retirement plan will. When you put money into your company’s 401(k), that money is separate from your employer’s books. Your employer can’t get to it, and neither can your employer’s creditors. It’s your money.

Chances are, unless you work for a publicly-traded company, you don’t even have the option of investing in company stock in your 401(k). More than likely, you have a menu of mutual funds to invest in. It would be very difficult—if not impossible—for your investment in these funds to drop in value to the point of being worthless. Remember that a mutual fund is a basket of stocks or bonds. Let’s say you invest in only one fund, and that fund owns the stocks of 70 different publicly traded companies. Every single one of those 70 corporations would have to go bankrupt and their stocks become worthless for you to lose all your money. That is not likely to happen. Even if it did, you probably won’t have all your money invested in just one fund; you’ll most likely be in four or five different funds. All together those five funds might be invested in 400 or 500 different companies’ stocks. The entire global financial market would have to be in a catastrophic, Armageddon meltdown for all 500 of those companies to go out of business.

Another issue that Enron employees had working against them was the blackout. Shortly before the company stock started its freefall, the company was in the process of switching from one retirement plan administrator to another. Following standard industry practice, they enacted a blackout period for the 401(k) plan while the assets were being transferred from one custodian to another. That meant that employees could make no changes to their account—they couldn't sell their company stock nor could they withdraw their money from the plan, even when the stock price plummeted to mere pennies. They were in a Catch-22.

The chances of you being caught in a similar situation are minuscule. You won’t be working for a huge fraud of an employer (hopefully). You won’t have all your savings tied up in your employer’s stock—so that even if the company goes bankrupt, you won’t lose your paycheck, your benefits and your nest egg. And if the stock plummets, your employer probably won’t impose a blackout period and freeze your plan.

So don’t worry. Your company’s plan is one of the best, simplest ways to invest for retirement.


How much should I put into company stock?

Don’t have more than 10% of your retirement savings in any one stock, especially not your employer’s. Personally, I wouldn’t have more than 5% in one stock.

Like I said, you probably do not work for another Enron. But remember, most of the folks at Enron didn’t realize they were working for a fraud—or not as big a fraud as they had thought. They trusted their company. They thought the company was doing great. They were emotionally attached to the company stock.

Never get emotionally attached to any stock. Minimize your potential losses by minimizing your exposure to it.

The tricky part can be when your employer matches your contributions to the 401(k), but they only match in shares of company stock. If that is the case for you, find out from your Benefits office when you can sell shares and move the proceeds into more diversified mutual funds. You may only be allowed to sell once a year or once a quarter. You might only be permitted to sell shares after owning them for a full year. Each employer has different rules, so you need to check to see what your plan allows.

Keep tabs on how much company stock you have, and what the value is. Whenever it gets to be more than 10% of your total retirement savings, sell some shares, if you are able.


How much should I contribute to my employer’s plan?

Well, how much does your employer match?

That’s how much you should put in.

I could just leave it at that and move on to the next question—because for most people it really is that simple. But you may want some further explanation.

When your employer matches some of your contributions, you are getting free money. Free money is pretty much always a good thing. I happen to be a big fan of people giving me free, legal money. I’d like everyone to do so. Unfortunately, most people—namely 99.999999% of the sane population—don’t want to give me any free money. I guess they’d rather spend it on something else.
If you are one of the fortunate people in America to have an employer that wants to give you free money, I suggest you take it.
All of it.

What if your employer is somewhat “stingy”? At least, that’s the word some of your co-workers may have used. You've probably heard them grumbling about the fact that, perhaps, your employer “only” matches 10% of your contributions to the 401(k). In other words, for every dollar of your hard-earned money you decide to put into your retirement plan, your employer “only” matches you a “measly” dime.

You've probably heard some of those murmuring co-workers say things like: “Well, I’m not putting anything into the 401 if all they’re doing is a 10% match.” There is a word for attitudes like this: foolish. (Not to mention ungrateful.)

That dime-on-the-dollar match means that for every dollar of your own pre-tax earnings you decide to put in the 401(k) plan, you get an instant return of 10% on that dollar! Chump change? I think not. The long-term historical average annual rate of return of the U.S. stock market is just a smidgen under 10 per cent. You get 10% just by showing up. If your employer matches 10 cents on the dollar, you just did as well as the stock market does in fairly good years—and you had no risk. That’s before you even go and invest that $1.10 into anything else inside the 401(k) plan.

Why would anyone pass that up? I would love to get a guaranteed 10% return year in and year out. Try going to the bank and asking for a 10% yield on a CD. Then watch as the bank manager doubles over with laughter.

Think of how much faster your retirement savings will grow because of that extra dime your employer chips in. For every $100 you contribute, your employer ponies up another $10. Skeptics would say that the difference between $100 and $110 doesn't add up to much. Skeptics are wrong. Let’s say that you have 25 years to go until you retire. And let’s say your diversified portfolio earns about 8% a year, on average.

If you invest just your $100 every month (and never increase your contribution—which is silly; of course you’ll bump it up almost every year), 25 years later, your account will be worth about $91,500.

But just by adding that extra measly $10 from your employer, your ending results look better. After 25 years, now your account is worth about $100,700. $100 thousand is better than $91 thousand. Your employer put in $10 a month for 25 years—that’s an extra $3000 added to your account, but it’s worth an extra $9000 to you at retirement age.

If that’s what a small 10% match does for your retirement results, think what a 25% or 50% match will do. Also, imagine what the difference will be if you invest much more than $100 a month, and you keep increasing your contribution every year.

So, the brief answer to the question “How much should I put in to my employer’s retirement plan?” would be: put in everything to get the full match. After that, you’re probably going to start a Roth IRA.


How do I get the most benefit out of my employer retiree plan?

In one word: Participate. Hopefully, you’re doing at least that much. Sadly, though, many people are not. Their employer has a perfectly good retirement plan available, with convenient pre-tax contributions made automatically each pay period, with an adequate selection of decent investments, and many times with “free” matching contributions from their employer.
And yet they still don’t take advantage of all those great benefits.

At some point, if you are one of those procrastinating fence-sitters, you are going to wake up, look at your retirement savings (or frightful lack thereof), smack yourself soundly on the forehead, and ask yourself, “What was I thinking?”

Remember what they say: “You can’t win if you don’t play.” That is probably misleading when it comes to the lottery—most can’t win even if they do play the lottery. It is very true when it comes to your retirement plan. If you don’t “play,” if you don’t participate by setting goals and setting aside a certain percentage of your pre-tax income—ideally 10% to 15% but less if that’s all you can do—and investing it for the long term, then you can’t win. You cannot build and accumulate enough wealth to last you a lifetime if you do not get started—and your company retirement plan is the easiest, smartest way to get started. You cannot reap what you do not sow.
You may despair that you cannot save anywhere close to ten percent of your salary at this point in your life. That’s okay. You’ve gotta start somewhere. How much can you save? Five percent? One percent? $20 a paycheck? Start small, but promise yourself—make a firm covenant—that you will increase it as soon as you can, even if it hurts to do so.

The other thing to do to get the most out of your company retirement plan is: get informed. Read this chapter carefully. Read through your plan enrollment book and ask for a copy of the Summary Plan Description from your benefits manager. Find out how much you can contribute to the plan, when you are able to get the money out, what the match and vesting schedule are, and what the other plan provisions are. If your company has a relationship with a financial advisor, make sure you speak with him or her. Ask questions. Stay on top of things—it’s your plan, after all.



How much can I contribute?

As we covered in the preceding answer, you should, ideally, be saving between ten and fifteen percent of your salary or gross income, if you are able to without having to sell any of your children. Most people are not able to do this right off the bat, but work their way up to the 15% range over the first few years of serious investing.

Maximum contribution limits

Keep in mind that there is a maximum amount you can save in a company retirement plan. The U.S. Government sets a limit of how much money we can sock away in our qualified plans each year, effectively sheltering that money from income taxation until we decide to withdraw it from the plan’s protection.

In 2013, the most you can put into your 401(k) plan is $17,500 if you are younger than age fifty. If you are 50+, you can put away no more than $23,000.

Other types of retirement plans may have different contribution limits.

Get the match!

If your employer offers matching contributions when you put some of your own money in the plan, by all means get the full match! Don’t leave that free money sitting on the table—grab it! Let’s say you earn $30,000 gross a year and your employer will match you dollar-for-dollar on the first 3% you contribute. If you only contribute three percent, just enough to get the match, you’ll be putting in $900 a year, and your employer will be adding another $900 to yours. Assuming you get paid twice a month, here’s how that breaks down per paycheck: You put in $37.50 every pay period, and so does your employer. At that rate, your money is doubling every time you contribute. Who wouldn't do this?

Now, your employer might not match dollar-for-dollar. Few do. But free money is free money, and I’ll gladly take whatever someone wants to give me.

Another reason that you should put in as much as you can is so you can actually see some results of your sacrifice, saving and prudent investing. If you’re only putting in $20 a month, it will take quite a while before your statement shows much more than a rather small pile of money. If you only have $240 in your retirement plan and it earns five percent this year, you’ll see your money grow by a whopping $12. That’s not very exciting. The more, the merrier.


Should I contribute more than the matched amount?

In other words, should you put in more money than simply the maximum amount that your employer matches? Or, put another way, if your employer, say, matches 50 cents on every dollar you put in up to six per cent of your pay, should you then put in more than six percent of your salary and wages?

The answer is a squishy: maybe. It depends on some ifs.

If you are in a fairly high tax bracket, and you’d like some more deductions, then putting more money into your pre-tax 401(k) probably makes sense. You reduce your taxable income with every dollar you put into your employer retirement plan.

If you are just barely in a higher marginal tax bracket for part of your income, putting more money into your pre-tax plan may allow you to slip down into the lower tax bracket and keep some money in your own pocket, rather than putting it in Uncle Sam’s.

For example, if you are married and you file a joint tax return, your marginal tax brackets depend on how much taxable income you earn. In 2010, the brackets were:
• 10% on the income between $0 and $16,750
• 15% on the income between $16,750 and $68,000
• 25% on the income between $68,000 and $137,300
• 28% on the income between $137,300 and $209,250
• 33% on the income between $209,250 and $373,650
• 35% on the income over $373,650

Now, this won’t apply to everyone, nor even to most people, but here is a scenario where contributing the maximum to your 401 plan might make sense. Let’s say you are a married couple, and your combined taxable income—after deductions, and after the $2000 a year you’re already putting into your 401(k)—is going to be $72,000.

Looking at the above chart, you can see that you are in the 25% tax bracket on any income you have above $68,000. In this case, that’s $4000 that will be taxed at 25%, whereas most of your other income will be taxed at a much lower rate—some at 10 per cent and some at 15 per cent.

That means, of that $4000 of income you earn above the $68,000 level, you will give $1000 of it to the IRS this year. If you’d rather not do that, one option would be to ramp up your savings in your retirement plan. Rather than only putting $2000 into your 401(k) this year, why not put $6000 or more in? That way you won’t have any income in the 25% tax bracket, and thus you will save yourself an extra $1000.

The other “if” to consider: If you know that you are not disciplined enough to invest on your own outside of your retirement plan, then by all means, max out your contributions in the 401(k) plan. Some people just are not able to go it alone—they forget to make contributions to another investment vehicle, or they put it off until it’s too late, or they find something else to do with the money. If you are one of those people (and be honest with yourself), then stick with the convenience of having automatic contributions coming out of your paycheck and going into your retirement plan. Remember, in 2010 you can contribute up to $16,500 to your 401(k) plan.


What is this vesting schedule? I thought this was my money.

If your employer offers a profit sharing contribution or matches a part of your deferrals into the plan, there may very well be a vesting schedule attached to those employer-contributed dollars.

The vesting schedule tells you how much of the employer’s dollars you can take with you, should you leave the company during your first few years of working there. The longer you are with an employer, the more of the employer’s money you get to keep. It’s pretty simple.

Your plan may have a vesting schedule of anywhere from three to six years. What this means is that if you leave the employer before the vesting schedule has run out, you won’t get to take all of your employer’s contributions with you.

For example, let’s say your employer’s plan has a five-year vesting schedule that looks like this:
After Year 1: 20%
After Year 2: 40%
After Year 3: 60%
After Year 4: 80%
After Year 5: 100%

If you leave the company, for whatever reason, after you have worked there for three full years (and the plan probably stipulates that you have to work for so many hours each year), you can take all of your own contributions and earnings from your contributions, but you’ll only be able to take 60 per cent of what the employer has put in your account, and the earnings from that 60 per cent.

Why does the employer do that? To reward productive employees that stick around and do a good job for several years. If you could take all the employer’s dollars with you at any point, you may be more likely to take a hike after working for the employer a relatively short amount of time.


What should I be investing in within the plan?

Here is the Reader’s Digest condensed version is: Spread it around.

Simply put, don’t put your eggs in one basket. Don’t put all your contributions into one fund nor in only one or two sectors of the market.

Financial markets are cyclical, unpredictable things. Sometimes they go up, very rapidly, for no discernible reason. Sometimes they go down, even more quickly, for no reason whatsoever. Markets move in cycles, and different parts of the market have different cycles at different times.

You don’t want to commit all your assets to just one investment category, because when that category is down, your entire account will be down as well. And that’s no fun to watch.

Your 401(k) plan probably offers a variety of funds in different investment categories. Spread your money around. Put some money in a large cap growth fund. Put some in a large cap value fund. Put some in a mid cap fund, and some in small cap. Definitely put some of your money in a good international fund to get overseas stocks. Maybe some bonds would help cushion your portfolio. If your plan has a real estate fund, that can also help you diversify.



How do I know which funds are good?

This is where things can get tricky. You are limited, in your employer-sponsored retirement plan (401k, 403b, 457) to the investment choices that your employer has selected to offer in the plan. That’s it. There are only so many items on the menu, and you can’t order anything that’s not on the menu.

Let’s say your employer plan offers twenty different investment choices. How do you know which ones are good and which are bad? This is a bit different than deciding what to invest in for your own personal portfolio or IRA, because in your 401(k) you don’t have the entire universe of funds available from which you can choose.

You’ll have to accept one thing up front as a given: You will not have the very best funds available in every investment category. In other words, don’t expect to see the #1 large-cap growth fund, the #1 international fund, the #1 high yield bond fund, etc. You may have some pretty good funds—and pretty good will be just fine. You may also have some mediocre fund choices with which you’ll have to live. And there may be a dog or two that you’ll want to avoid.

Performance
So how does one evaluate the funds that are on the menu? The obvious answer is to look at the performance of the funds in each investment style or category. This is what most people do, and as a first step, it’s not an awful place to start. But it won’t be enough. Many people, though, only look at returns, and simply pick this year’s top performing fund. That is a mistake.

When you look at the performance of the funds available in your retirement plan, keep in mind you are looking at past performance only. And, as everybody knows: past performance does not indicate future results. In other words, what they've done ain't necessarily what they’re going to do.

But take a look at the long-term track record of the fund. Don’t worry too much about the year-to-date (YTD) performance or the one and three year average annual returns. I’d focus on the five and ten year returns. I especially like to see how a fund has done over the past ten years—because the last ten years include some of the over-hyped bull market of the late 1990s, the three absolutely horrible bear market years of 2000-2002, and a few very good years since then. So the 10-year average annual return will tell me how this particular fund I’m looking at did through good times and bad. You would hope that the fund at least had decent-to-mediocre returns over the last ten years; you don’t want to see a lousy, anemic 10-year average return.

Even if the fund has had a pretty good track record over the last ten years, what does that tell us about how it will do over the next ten years? Perhaps nothing. The next ten years could be completely different—geopolitically, macroeconomically, for that particular style of fund, or for some of the industries in which the fund has significant assets. So past performance only tells us so much.

Tenure and experience
How long has this manager been running this particular fund? That’s important to know. If the fund you’re looking at has a stellar 10-year track record, but you find that the fund manager has only been running it for one year, proceed with caution. Nine of those good years had nothing to do with the current manager’s expertise or acumen. Look for funds that have been run by the same manager for several years.

You would also want your fund manager to have some experience. In the late 1990s, many “hot” funds were being managed by people with two or three years’ experience managing money. Needless to say, they didn’t fare well when the bubble burst.

Holdings
Within the one fund you’re looking at, you want to make sure the fund isn’t too heavily overweighted in any one stock, or in any one sector of the economy. For example, you may see that 40% of the fund’s holdings are in financial stocks—banks, insurance companies, mortgage lenders, etc. If the financial sector takes a sharp drop—as it did in mid-2007—then that fund’s performance could take a sharp hit as well. Some funds were very overweighted in technology in 1999 and early 2000, because that industry had seen unbelievable growth in the late 1990s (truly, it was unbelievable; no one should have believed the hype). Those funds, and the shareholders of those funds, suffered terribly when the tech bubble burst in March 2000.

Similarly, if you are looking at an international fund, a red flag should go up if 30% of the fund’s assets are in, say, Brazilian stocks. That’s a pretty big bet the manager is placing on one country. If that country’s economy experiences a sharp, swift southward turn, that fund is going to take a dive as well.

You need to do your homework, and make sure the manager isn't taking on too much risk by concentrating on one single part of the portfolio.

The problem you’re likely to run into? Your 401(k) materials, including enrollment books or the provider’s website aren't likely to have much information on the funds. They may show you just the top ten holdings in each fund. If your 401(k) plan is using actual mutual funds, then you can use the “ticker” symbol (a five-letter code that lets you search for the fund on websites that provide stock and fund “quotes”) to look up more information on Morningstar’s website, or Morningstar reports at your public library. Morningstar may allow you to get more in-depth information. However, if your fund is in some type of annuity contract (which you might not even realize, but many group retirement plans are), there are no ticker symbols, and it is not as easy to find more information.

Get help
Call someone who knows what they’re doing. Again, this is where an experienced, knowledgeable financial adviser can help. If you already have an adviser, make an appointment to see her to get some help with selecting the funds you want to use in your employer’s plan. She probably has access to more information, and can help you winnow out the bad funds, and narrow down your attractive choices.

Your adviser can help you select the right mix of funds, ensuring that you’re not too heavily or too lightly invested in any one area, and that your investment choices are the right fit for your risk tolerance and time horizon. If you have investments outside of your company plan, your adviser should help you make sure your various investments aren't working at cross purposes.


I’m no financial whiz. Isn’t there a simpler way to pick my funds?

Many plans do offer a simpler way. They’re called Asset Allocation funds or Target-date funds.

Asset allocation funds
If you know what type of investor you basically are, you can choose one asset allocation fund that will, more or less, give you the right mix of investments to match your risk tolerance. If you’re a very conservative investor, you may want to choose a Conservative Allocation fund which might have 65% of assets invested in bonds or cash, and only about 35% in the more volatile stock market. Conversely, an Aggressive Allocation fund would have the majority of assets—from 65 to 80 per cent—in stocks, with the remainder in bonds or cash.

Asset Allocation funds are pretty much static. The manager may change the holdings and the percentages in stocks and bonds based on changing market conditions, but don’t expect these portfolios to vary a great deal. On the plus side, you pretty much know what you’ll be getting. The negative is that asset allocation funds don’t change as your investment time horizon and your risk tolerance change.

Target date funds
These are your true one-stop shopping funds. If you don’t want to go through the headache or hassle of putting together your own tailor-made portfolio of funds, and you don’t want to worry much about changing your mix as you get closer to retirement, this may be a simpler option.

If your plan offers target date funds, they probably offer three or four of them. You’ll probably see a date associated with the fund, like 2020, 2030 or 2040. These dates refer to your approximate year of retirement. When are you going to check out of the rat race? You’d want to pick the fund closest to your estimated Freedom Date.

Let’s say you are going to retire somewhere around 2030, give or take a few years. If you invest money in that Target 2030 fund, the manager is going to diversify your assets for you, putting your dollars to work in a prudent, sensible mix of large-cap stocks, small-cap stocks, international stocks, bonds for someone who is going to retire somewhere around 2030. At the time of publication, that’s over 20 years away. Consequently, this fund will primarily be invested in stocks—probably 80 to 90 per cent of the fund will be in broadly diversified equities.

But here’s the best thing about these target date funds: each year, as we get closer and closer to that target retirement date, the fund manager will ease off the gas pedal just a bit. Thus, as you get closer and closer to the year 2030, you’ll see a bit more of the fund’s assets shift from more volatile stocks into more stable bonds. This way, the manager is helping you minimize the market risk that would ravage your portfolio if you were still 100 percent in stocks, and the market hits the skids shortly before you retire. By 2030, this target fund would probably have 60 per cent or more of its assets in bonds or cash, so a minority of your retirement dollars would be at risk of a stock market crash.

Take a look at the target date offerings in your plan to see if you have a lifestyle or target-date fund. They are becoming more and more popular with 401(k) sponsors and with investors for their utility and simplicity. Some people who want to keep things extremely simple will put 100% of their contributions in a lifestyle fund. Others prefer a mix of target date and selecting sectors. Those wanting more variety, and perhaps a bit more control, may put 50% of contributions in a target date fund, but then pick their favorite large cap growth, large cap value, small cap, and international funds for the other 50 percent.


Should I shift strategies when the market goes down?
Or when the market takes off?

I’ve said it before, and I’ll say it many, many times: Your retirement plan is for your retirement. Your retirement is, probably, a long way away. You should have a long-term mindset. If you’re retiring 20 years from now, you should be concerned with what your account balance will look like 20 years from today. It doesn't matter what your account looks like today.

But, you say, the Dow had a 300-point drop today!

So what? That 300-point move in the market, while it may be big and dramatic news today, won’t even be a memory in two decades. I’ll give you the same advice I follow myself:

• Get a good mix of funds and stick with it. That’s it. It’s pretty simple. I’m well-diversified among large cap funds (growth and value), small and mid cap funds, international, and a little bit of bonds. I stick with the same funds. I don’t play around with the mix, and I don’t swap around every time the wind changes direction. In the short run, sure, a couple of my funds might be out of favor today, but I hang on to them, because I know that eventually, they’ll be back in style.

• You can’t time the market. Repeat this after me: “I cannot time the market.” If it’s headed down right now, you don’t know when it might suddenly go up again. And vice versa. The market is unpredictable. People are unpredictable—and people are the market. Remember, the biggest determinant of how successful you are as an investor will be the length of time you are in the market, not whether you can time the market.

• Don’t get greedy when market goes through the roof. It’s tempting, I know. The tendency is to want to be more aggressive than you should be. If there’s one hot sector, you may feel the urge to put a bunch of your money in that part of the economy. I’ve known many 401(k) participants who put all their money in the one fund in their plan that had the best performance that year. This is never a good idea. You need to stay diversified, and not let your emotions get the better of you. If you go whole hog into one fund, when that fund drops—and it will, eventually—then your whole account balance will tumble.

• Don’t get scared out when market drops. Again, control your emotions. The market moves in cycles. From time to time, there will be corrections. Every few years, there will be bear markets. It’s as natural as winter coming every year. Don’t get scared out just because your account balance drops a bit. The dips are the opportunity. Let me say that again: The dips are the opportunity. That’s when your contributions buy more shares of the funds in which you’re investing. Just stick with it. Don’t open your statements for a while, if that will help. I didn't open a single 401(k) statement of mine in 2001 or 2002, or in 2008. I didn't want to get depressed.

• Ignore the news. I don’t mean stick your head in the sand. You still can look at your quarterly statements (if you promise not to overreact). But ignore the headlines and news stories that are designed to sell advertising by being overly dramatic. You know: “Market Plunges 101 on Fears of…” What happens in the market today won’t mean a thing in 20 or 30 years.


I need some cash. Should I borrow against my 401(k) plan?

I wouldn’t if you don’t have to. If you can borrow the money from some other source—a generous aunt, mom and dad, or your home teacher—you might want to try that instead (just kidding about the home teacher). When you have a pile of investment assets just sitting there in your 401(k), not doing anyone any good, it’s tempting to want to tap into the retirement plan to pay for other things you need (or want).

First of all, you might not be able to borrow from your employer’s 401(k) plan. Not all plans have a loan provision. You’ll want to check with your benefits manager or check your 401(k) Summary Plan Description to see if you can even take out a loan.

Loan provisions vary from plan to plan. Usually, you can only borrow up to half of your account balance, and you cannot borrow more than $50,000. You can probably have only one loan at a time. You usually have to pay the loan back through payroll deductions within five years. You’ll be paying yourself back with interest; the interest rate might be one or two percent above what the going Prime rate is.

But should you borrow against your 401(k)? As I said, probably not. Here’s why you might want to think twice—or four times—before you take out a loan:

1. When you borrow money out of your plan, that money is no longer invested in the market. In some years—like 2008—that would be a good thing, so that your assets don’t go down in value when the market tanks. But in years where the market has a big upswing, any money you have borrowed from your 401(k) will not participate in those gains. That money is sitting on the sidelines.

2. When you’re paying back your loan, you’re not investing as much new money. Your extra disposable income is going to repay the loan you took out. In fact, many people that take out loans reduce their ongoing 401(k) contributions. This can have big, negative consequences in the future. The less you are investing while you are far away from retirement—especially during down markets when stocks are cheap—the less money you will have in retirement. It’s just that simple.

3. Here’s something most people don’t think about before taking out a loan. Let’s say all the money in your 401(k) is pre-tax. You never paid taxes on your contributions as they went in. You borrow, say, $5000 from your plan and use it to pay bills (or whatever). You start repaying it through payroll deductions. Those payments are deducted from your paycheck after taxes. That’s right: you are borrowing pre-tax dollars, and paying back with after-tax dollars. Then, once you have paid back the whole loan plus interest, when you retire and withdraw that money, what is the government going to do? They will tax you again on that same money. The government gets to double-dip you, and it’s all perfectly legal.

4. When you take out a loan, you have to pay it back within five years. So, let’s say you set up a five year repayment schedule, and you begin repaying your loan. But after two years, you’re laid off unexpectedly. What happens to the other three years’ worth of payments you were supposed to make? You will have to pay off the rest of the loan at once, coming up with the cash out of your own pocket. What happens if you don’t have the cash? Then the government determines that whatever you borrowed but didn’t pay back was a distribution from the plan. That means you owe taxes on it and, if you’re younger than 59 ½, you must also pay the 10% penalty for early withdrawal. Yowch. Most people don’t think that they will lose or change their jobs before they pay off the loan, but it happens and it can be costly.


When can I get my money out?

The better question is: When should I get my money out of my retirement plan? Well, I’ll give you a hint: The key word in that question is “retirement.”

Keep in mind that this is a retirement plan. You really shouldn't even want to get your money out until you are retired. That’s the whole reason you’ve been saving a portion of your paycheck every payday—so that when the paychecks stop, the distribution checks can start. And that’s the whole reason the government has been giving you some nifty tax benefits—because Uncle Sam knows that you’d better have some serious coinage saved up for when you retire, because Social Security isn't going to cut it.

Participants in 401(k) plans often ask me why they can’t withdraw their money whenever they want. Some people seem to think that the 401(k) plan (or 403b or SIMPLE IRA, etc.) should function like some short-term savings account. They want to conveniently save some money from each paycheck, earn a nice stock-market rate of return on it, but be able to pull the money out whenever they want so they can spend it on Christmas presents, Alaskan cruises, or recreational vehicles. Or whatever. So why can’t they?
It doesn't work that way. Since the government created and gave their blessings for 401(k) plans, and since they allow us to enjoy these tax breaks on the money we contribute, the government gets to set the rules. If you want to participate in the 401(k) plan, you have to play by the government’s rules.

One of the big rules is that you cannot get your money out whenever you want. The government wants you to keep the money in there until you reach retirement age. The magic number, as far as the government is concerned, is age 59 ½. Why age 59 ½, you ask? I have no idea. But that’s what they decided. They’re the federal government. They don’t have to make sense. We should wait until at least age 59 ½ to retire. Their tax code, their rules. If you pull your money out before retirement age—if you’re even allowed to—you’ll probably pay a hefty penalty to the IRS, on top of your regular taxes. Taxes and early-withdrawal penalties don’t sound like much fun.

If you wait until after you reach age 59 ½ to withdraw your money, you’ll pay regular income taxes on it—both federal and state income taxes (if your state has an income tax)—because you haven’t paid taxes on any of the dollars you’ve put into the traditional retirement plan yet. But you won’t pay the extra 10% penalty that you’d have to pay if you pulled the money out pre-59 ½.

Here’s another rule: while you’re still working with your employer, you can’t withdraw money from your employer’s 401(k) plan. You can usually only get access to the money when you leave the company—if you quit or you are terminated. At that point, you are “separated from service,” and that is a distributable event. So, if you leave your employer, you can get your money out of the plan.
But should you? Should you just cash out when you leave your job?


What if I leave my employer? What should I do with my 401(k) balance?

This is a very good question, and one which many Americans don’t ask ahead of time. It is absolutely essential that you know the right answer to this question well before you leave an employer, and that you fully understand your options about what to do with your 401(k) assets.

The good news about your retirement plan money is: It’s portable— you can take it with you. That is, when you leave an employer, your money does not have to remain in your employer’s plan. You can take it with you to your next employer, if you so choose.
Keep in mind that you can only take with you your vested account balance, which will usually be all of your contributions and earnings, and the percentage of your employer’s contributions and earnings to which you are entitled, based on how many years you have worked for that company.

When you separate from service, that is, when you leave the employer for whatever reason, you are allowed to get your money out of that retirement plan. There are a couple of right ways to get your money out, and one very wrong way.

Cashing out
The wrong way that far too many people choose when they leave an employer is to cash out. If you quit or are let go, please do not cash out your 401(k) plan. Don’t do it unless you want to pay a huge chunk of money to the government. If you cash out, you will have to pay federal income taxes on your entire traditional 401(k) balance (since all the money in the account is pre-tax; those dollars now have to be taxed) and you’ll have to pay state income taxes on the whole amount (if you live in a state with an income tax). If that weren’t bad enough, if you are younger than 59 ½ years of age, you will also owe an additional penalty to the IRS—another 10% of the whole account balance when you cashed it out. This is the early withdrawal penalty that you are hit with, because you’re pulling money out before retirement age.

When you tally all those taxes and penalties up, it could add up to 30% or 40% of your account. Gone! POOF! Just like that—you’ve lost 30 or 40 per cent of your retirement savings. That’s painful—it’s as bad as a stock market crash, except you did it to yourself! That’s worse!

Transfer to a new employer plan
So, what are the better options? The first is to roll the money to a new 401(k) plan. If you leave employer A and go work for Employer B, check to see if Employer B has a 401(k) plan. Ask to take a look at some information about the plan—fund choices, performance track record, plan provisions, etc. If the plan looks good to you, see if Employer B’s plan will allow you to roll in your balance from Employer A’s plan. Most 401(k) plans will allow you to do so—even if, as a new employee, you aren't yet eligible to put new contributions from your paycheck into Company B’s plan.

Technically, what you are doing isn't a “roll-over,” it’s a “transfer.” You are having your money transfer directly from Employer A’s plan to Employer B’s plan. You want to avoid doing a true “roll-over,” where Employer A’s 401(k) administrator would cut you a check and send it to you, for you to then put into another plan. Please remember: if they cut you a check, they will withhold 20% for taxes and send it directly to the IRS. By law, the 401(k) provider has to do this. Wait a minute! I don’t want to pay taxes on that money, you may say. If you don’t want to have the taxes withheld, then don’t do a roll-over. Do a direct transfer from the old plan to the new. You’ll fill out some paperwork for Company B’s plan, to have the money roll in, and you may need to get some paperwork from Company A as well, if you want the transfer to go smoothly. It may take a few weeks for the transfer to happen, but when it does, your entire vested balance transfers from Company A’s plan into that of Company B, and you owe no taxes or penalties. The money is still earmarked for retirement.

Roll over to an IRA
What if Company B doesn't have a retirement plan? Or what if you decide you don’t like Company B’s plan? That brings us to the second option. Open up an Individual Retirement Account and have your balance from Company A’s plan transferred directly into the rollover IRA. The same rules apply. As long as the money doesn't come to you, no taxes are withheld and no penalties are due. Once the money is safely inside the IRA, you can put the money to work in whatever investments are available in that IRA account with that institution. You can open an IRA with your bank—but you might only be able to “invest” in a certificate of deposit. You can open an IRA with a mutual fund family, like Fidelity or Vanguard—but you’ll likely only be able to invest in funds from that one mutual fund family.

Leave it there
If you like Company A’s plan, can you leave your money there? Yes, you can—if you have at least $5000 in your account. If you have a balance of less than $5000, your former employer can make you move the money elsewhere. That’s because your former employer doesn't want to keep track of dozens or even hundreds of small accounts of former employees.

The upside of leaving the money at Employer A is that it can give you time to figure out where you’re going to land. Maybe it’s taking longer to find Employer B than you thought. Perhaps you’re already working for Employer B, but it’s taking a while to get good information on the new 401(k) plan. Perhaps you’re not sure if you want to stay with Employer B very long. Or maybe you’re just emotionally attached to your funds in the Company A plan. Whatever the reason, you do have the option of leaving your money where it is.

The downside of leaving the money with Employer A is that you cannot keep adding to your account with Employer A once you leave the company. You’re no longer on the payroll, and the only way you can add new dollars to the plan is through payroll deduction. Another drawback that can be a headache is the Multiple Statement Syndrome. Some people that leave “orphaned” 401(k) accounts behind every time they leave an employer often find themselves buried under an avalanche of statements every three months. To simplify your life (and save a few trees), you may want to consolidate your assets into one or two accounts at most.


What if my company doesn’t offer a retirement plan? Or what if I don’t like some of the provisions of the plan?

The first thing you should do, if there is no retirement plan where you work, is to tell your employer you’d like one. Politely. Sometimes employers don’t offer certain benefits because they think employees are not interested. Tell the boss you are interested in saving for retirement. Get some other likeminded co-workers to convey the same message. There’s no guarantee that he’ll start a plan, but he just might, if he thinks enough good employees want one.

You see, that’s what employers want. They want to keep good employees. That helps the business run smoothly and productively. If you can go get a benefit by working with another employer, it may be in your employer’s best interest to offer that benefit to you.
If you don’t like something about your company’s plan, say so—politely. If you think your investment choices are too limited, or just plain lousy, let your employer know. If you think your plan should allow Roth contributions, say so. If you think the plan should allow you to change your contribution amount more frequently than twice a year, speak up. Again, most employers don’t think that anything is broken, and so they never think about fixing it. The squeaky wheel often (but not always) gets the grease. The way I would approach it would be: “I thank you for offering this plan. It is a very convenient and simple way to invest for the future. One thing that I think would make it even more attractive is…”