More than 20 million Americans are counting on their 401(k) investments to help see them through retirement. Some predict that 401(k) holdings will grow from $500 billion to more than $2 trillion by 2006.1
However, recent news reports of corporate corruption and slow economic recovery have many concerned about the safety and viability of their investments. As a result, we’ve contacted two experts to answer questions from alumni about the most popular retirement plan—the 401(k).
Stacy Allred is a relationship manager in family office services at Merrill Lynch in San Francisco. She is a certified financial planner and specializes in the areas of retirement, estate, investment, stock option, and tax planning. She earned a BS in accountancy from the Marriott School in 1991 and a master’s in taxation from Chicago’s DePaul University in 1996.
Bryan Sudweeks is a Marriott School associate professor of business management and certified financial analyst with nearly twenty years professional experience. He received his BS from BYU in 1980, his MBA from BYU in 1982, and his PhD in business administration from George Washington University in 1987.
How do I know if I should contribute to my employer’s 401(k) or establish my own traditional IRA account?
Allred:
I recommend looking at the following factors:
- Company match. If your company offers a 401(k) match, contribute at least the amount of the match into your plan. If you were offered a 3 percent raise, would you decline it? Don’t leave money on the table by not taking advantage of a company match.
- Simplicity. If you are already contributing to a 401(k), and the plan has good investment choices, generally you are better off maximizing your 401(k) and avoiding the hassle and annual expense of another account.
- Investment choices. Are the investment choices in your company 401(k) plan adequate? Many 401(k) plans offer a nice variety of funds. An IRA has a wide range of investment choices. However, too many choices can be overwhelming to those without a lot of investment experience or without the help or tools to analyze the choices.
- Tax deductibility. If you are covered by a 401(k) plan at work and have high income, an IRA contribution may be non-tax deductible.
- Overall limits. The 401(k) plan has a higher limit than the IRA—$11,000 versus $3,000.
Sudweeks:
You need to first understand and set your retirement goals based on how you want to live during retirement—then you can find the investment vehicle to help you best attain those goals. The following list outlines a priority of money for retirement:
- Free money. Free money is matched by your company through a 401(k) or other retirement plan. This should be your first source of retirement money because it’s free and results in immediate return. In 2002, you may invest, not including a company match, up to $11,000 in a 401(k).
- Tax advantaged money. This money has special tax advantages such as the Roth IRA. While your money is invested in after-tax dollars, principal interest and capital appreciation are tax-free regardless of your tax bracket at retirement. In 2002, you can invest up to $3,000 in a Roth IRA.
- Tax-deferred money. This money is invested before tax and grows tax deferred. At retirement, principal interest and capital appreciation are taxed at your retirement tax rate, which is likely to be lower than your current tax rate. You can invest up to $3,000 in an IRA account, $30,000 in a Simple Employment Plan (SEP) IRA or self-employed plan, or other amounts depending on the types of investment vehicles available to you.
- Tax-efficient money. It’s unlikely you’ll save all the retirement money you need through the aforementioned investment vehicles. Additional money you save should be in accounts that minimize your current taxable income such as index funds, which minimize current income and defer capital appreciation until they are sold, or tax-free bonds or bond funds that require no state or federal taxes. There is no limit to the amount of money you can save for retirement through tax-efficient investing.
How often should I review and/or change my investment mix?
Sudweeks:
One of the most important documents you will develop is an investment policy statement or investment plan. This is where you articulate critical decisions regarding your investment policy. For example, you might address what you will or will not invest in, your investment return and risk requirements, constraints, asset allocation mix, investment strategies, funding strategies, and new asset strategies. It also includes how often you will review your portfolio performance and which benchmarks you will use to determine how well your investments have performed.
Generally, performance should be reviewed quarterly, semiannually, or annually. Rebalancing of major asset class decisions should only be done annually. Rebalancing too frequently may result in “churning” your portfolio, which brings lower returns.
If you rebalance too infrequently, your portfolio may not be diversified enough—with too many retirement dollars in a single asset class.
If I change jobs, what options do I have with my 401(k)?
Allred:
The Economic Growth & Tax Relief Reconciliation Act of 2001 expanded the portability of retirement plans. For example, after-tax contributions to a 401(k) plan can now be rolled over to an IRA. As long as your balance is more than $3,500, you generally have the option of keeping the balance with your old employer or rolling it into a new 401(k) or IRA.
Many Enron employees lost a good portion of their retirement savings because their 401(k) was so heavily invested in company stock. What should I consider when deciding how much of my employer’s stock to carry in my 401(k)?
Sudweeks:
As part of your investment policy statement, you will have to answer this question. As I help individuals develop their policy statements, I generally recommend they keep no more than 10 percent of their retirement portfolio in company stock.
Allred: I recently asked a group of employees, “What type of investor are you?” Almost all of them answered “conservative.” Yet when I reviewed their 401(k) plans, they had 100 percent of their investments in company stock—a very aggressive choice.
Investment fund managers usually hold at least twenty company stocks and have no more than 5 percent in any one company. I would generally limit the amount of company stock to between 5 and 10 percent of your overall assets. Remember to take into consideration other dependence on company stock such as: employee stock option plans, employee stock purchase plans, and company shares held outright.
Should I ever consider taking a loan against my 401(k)?
Allred:
Borrowing from your 401(k) plan may sound like a good idea, but be careful and look at all the angles. When you borrow from your retirement savings, you lose the future compounding on the lost earnings. For example, if your loan costs you 7 percent and you were earning 9 percent in a stock mutual fund, your lost opportunity cost is really 9 percent.
Also, keep in mind that loans are usually due when you separate from your employer. If you can’t pay off the entire balance, the loan balance is considered taxable income and is subject to a 10 percent penalty for those under age fifty-five. Except in extreme circumstances, I like to see money left in the 401(k) plan doing what the plan is designed to do: grow for retirement.
Sudweeks: One of the problems of taking loans from a 401(k) plan is that people consider this free money—it isn’t. There are consequences. People generally consider these options when they have not been wise financially, bought too much on credit, and need to bail themselves out.
Bad financial habits are usually not corrected by 401(k) loans. Spending will increase again, and more loans will follow. It’s much better to address the problem immediately, cut back on spending, and get your financial house in order than to continue to practice taking out loans from investment accounts—resulting in the eventual loss of retirement funds.
How am I taxed on the money I take out of my 401(k) plan?
Allred:
401(k) distributions are taxable as ordinary income in the year you receive them. However, a special planning opportunity exists to get capital gains treatment on company stock held in your 401(k). If you have highly appreciated company stock in your plan, work with a planner who is familiar with these rules to see if you can take advantage of this opportunity. If this situation applies to you, review the rules on “Net Unrealized Appreciation” before you roll your 401(k) plan into an IRA.
What are my 401(k) withdrawal options during retirement?
Sudweeks:
One withdrawal option is periodic payments. The advantage of this option is that you receive regular payments at regular intervals, and these are usually relatively large payments. The disadvantages include no assurance of lifetime income and a high tax rate for those with high income.
Another option is an IRA rollover—but be careful not to touch the funds. An IRA rollover allows you to defer taxes until you withdraw funds. You can also direct your investment and enjoy tax-deferred growth. The downside of an IRA rollover is you have to wait until age fifty-nine and a half to withdraw without penalty.
How long can I leave money in my 401(k) plan?
Allred:
You can leave your money in until 1 April following the year in which you turn age seventy and a half. At that point, you are required to make minimum required distributions (MRD) over your life expectancy. The IRS recently issued new rules that simplify the calculation of MRD. If you don’t make the MRDs, one of the IRS’ harshest penalties would apply: a 50 percent nondeductible excise tax of the under-distributed amount. You can take out more than the minimum required.
ACTIONS TO CONSIDER
- Take advantage of company matching programs.
- Develop a personal investment policy statement.
- Limit rebalancing your portfolio to once a year.
- Don’t invest more than 5-10 percent of your overall assets in any one company stock.
- Avoid taking a loan against your 401(k), except in extreme circumstances.
- Carefully consider your best method for withdrawing 401(k) savings.
Endnote:
- Bonnie Miller, “Looking at Your 401(k) Withdrawal Options,” Chaffey Federal Credit Union web site, www.chaffey.com/hffo9907/0799_b.htm
