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I'm doing all my retirement saving in my 401(k), although as far as choosing the actual investments, I'm getting help from a financial adviser. Is there any inherent risk in putting all my retirement eggs in just my 401(k) basket?
-- Mike Horak, Bellevue, Nebraska
I'm sure you're not alone. I don't have any stats on hand to back this up, but I suspect that many Americans do, if not all their retirement savings, then certainly the bulk of it through a 401(k) or some other form of employer-provided savings plan.
One reason, of course, is the convenience. The money is transferred from our paycheck to our 401(k) account before we can get our greedy little hands on it. Believe me, that counts for a lot. And then, of course, there are the tax advantages.
The money you contribute to your 401(k) lowers your taxable income each year, and thus your tax bill, plus the earnings on your contributions compound free of taxes until you pull the money out. And on top of that most employers offer a matching contribution that is essentially free money.
So for all those reasons, I think 401(k)s and similar plans make an excellent foundation for a retirement-savings portfolio -- assuming, that is, that your plan has a broad enough array of investing choices to allow you to build a diversified portfolio.
Don't forget to diversify
For most 401(k) participants, a decent menu of choices isn't a problem. According to the Profit Sharing/401(k) Council of America's latest annual survey of profit sharing plans and 401(k)s, roughly 70 percent of 401(k) plans offer 10 or more different investing options, and the average number for all plans surveyed was 15.
That's not to say that there aren't some 401(k)s out there with a mediocre or even lousy menu of funds to choose from. But if you're working with a decent financial adviser, then that person should be able to help you get the most out of your plan.
But while I think we should all take full advantage of 401(k)s and other employer provided plans -- that is, contribute as much as we can and certainly enough to take full advantage of any employer match -- I think there are good reasons why we should also try to do saving and investing outside a company-sponsored plan.
Watch out for limits
For one thing, there are limits to how much you can sock away in a 401(k). There's the federal government-imposed limit of $11,000 for 2002, which rises to $15,000 by 2006. But individual plans also limit contributions to a specific percentage of salary, usually between 6 percent and 9 percent, which means you may not even be able to reach the federal maximum.
If your plan allows you to contribute 9 percent of salary, for example, and you earn $80,000, then the most you can contribute is $7,200. Even if the company provides a 50 percent match -- $3,600 -- you're saving a max of $10,800. That's a nice piece of change, but on its own it may not enough to provide the type of nest egg you'll need to maintain your lifestyle in retirement.
So to prevent yourself from possibly having to downsize your standard of living in retirement, I think it's a good idea to salt away savings outside your 401(k).
Certainly, you should consider other tax-advantaged accounts like traditional IRAs and Roth IRAS, assuming you meet the income requirements. But I believe there's also a good argument for savings and investing outside tax-advantaged plans as well. And that argument is diversification, or more specifically, tax diversification.
Taxable or non-taxable savings?
You see, when you eventually pull your gains out of your 401(k) and an IRA (though not your Roth IRA), they will be taxed as ordinary income. That's true even if those gains are long-term capital gains, which are normally taxed at lower long-term capital gains tax rates.
This means that if all your retirement savings are in a 401(k)or account that's taxed in the same way, your fortunes are tied completely to ordinary income tax rates. If Congress decides to boost those rates while you're retired -- hardly a far-fetched notion -- then all your income is subject to the higher rate. You have virtually no maneuvering room.
Myself, I like to have options. Which is why I also like to hold investments such as mutual funds or stocks in taxable accounts. That way, any long-term capital gains I get from my investments are taxed at generally lower long-term capital gains rates.
That's not to say I'm 100 percent sure they'll be lower in the future. Hey, Congress has done some pretty zany things with the tax code, so nothing would surprise a skeptic like me. But by having investments that generate gains that are taxed at long-term capital gains rates as well as ordinary income rates, at least I'm hedging my bets a bit.
At least there's a chance I'll be able to structure my withdrawals in retirement so that I can keep the most money in my pocket and turn over as little as (legally) possible to Uncle Sam.
That said, however, I still think for most of us the first priority is to max out on our 401(k)s and similar plans and then go looking for additional places to stash our savings. After all, the biggest inherent risk I see in retirement planning isn't that we won't save in the right places, but that we just won't save enough at all.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.