SMART WAYS TO REV UP YOUR 401(k)
The markets are placid and your 401(k) is on autopilot. But the tax laws have changed--and so should your retirement planning.
By JANICE REVELL

(FORTUNE Magazine) – When you look back on 2004, you're more likely to remember the impassioned mudslinging of the presidential election than to recall what has been a quiet year for the markets. Despite any number of potential upheavals--the election, high oil prices, turmoil in Iraq--the S&P 500 has delivered a calm 7% return through early December. Nothing has happened, it seems, that should cause you to reevaluate your retirement saving strategy, and there's a good chance you're planning to steer a steady course in 2005.

But while the markets' performance may seem to imply that now is a good time for a long snooze on the couch, nothing could be further from the truth. Congress has been instituting changes in recent years that alter many long-standing assumptions about retirement planning. The Bush administration's tax cuts, for example, have made wise asset allocation more important than ever. Moves that may not have made much difference a couple of years ago could now add thousands to your retirement nest egg. And there are more changes around the corner, including the rollout of a new type of 401(k), that could radically affect how you save for retirement. A few experts are even arguing that the 401(k) shouldn't be the primary savings vehicle for some people. The end of the year is always a good time to revisit your planning, and for all its seeming placidity, 2004 is definitely not an exception.

Before we highlight what has been changing, let's pause to remind ourselves of two often cited (and equally often forgotten) pieces of advice. The first is possibly the single most important thing you can do in your retirement planning: Minimize the fees you pay. That's even more crucial today, when experts predict that 6.5% stock returns will be the norm. Paying 1.5 percentage points of that to the average actively managed mutual fund--vs. 0.2% for an index fund--means you are giving up 20% of your returns every year.

The second maxim concerns the dangers of holding your own company's stock in your 401(k) account. Legions of financial advisors and media pundits sounded the alarm after Enron and WorldCom employees saw their retirement savings go up in smoke. But many people didn't get the message. According to the Profit Sharing/ 401(k) Council, 17% of all 401(k) participants have 50% or more of their account in company stock--virtually unchanged since the collapse of Enron. As the recent debacles at drugmaker Merck and insurance brokerage Marsh & McLennan illustrate, even the stablest companies can tank in an instant. So one more time: Don't buy company stock in your 401(k). What if your match comes in that particular currency? Fortunately, a growing minority of companies are allowing employees to bail out. About 36% of employers that match 401(k) contributions in company stock now permit staffers to diversify out of the shares, according to employee-benefits consultants Hewitt Associates. That compares with 15% in 2001.

Okay, now that we've gotten the sermonizing out of the way, let's look at what has been changing. Most investors recognize that how they mix stocks, bonds, and other assets is critical to the success of any retirement savings program. (The general targets for retirement asset allocation, subject to your personal circumstances, run as follows: At 30, you might aim for 85% stocks and the rest in bonds. At 45, you'd shift to 70% in stocks, and at 60, you'd reduce your stock portion to 60% of the portfolio.) But the tax cuts of recent years mean you may need to rethink the way you distribute those assets among taxable and tax-deferred accounts--call it asset location rather than asset allocation. "For the most part, people are doing the wrong thing," says Robert Dammon, a finance professor at Carnegie Mellon University and co-author of a widely acclaimed new study on the subject.

Here's the problem. Investors typically allocate their investments the same way in both their taxable and 401(k) accounts--about 70% stocks and 30% bonds in each. But that approach can eat away 15% to 20% from investors' retirement nest eggs, according to Dammon's study. The reason lies in the different tax treatments accorded to stocks and bonds. Interest on bonds is taxed at ordinary income rates, up to 35%. By contrast, long-term capital gains and dividends on stocks are now taxed at only 15%. But all the money in your 401(k) will be taxed at ordinary income rates when you withdraw it. So if you put stocks into your 401(k), you will forfeit the more favorable capital gains treatment.

The solution: Move your bonds to your 401(k). Let's say you want to save $20,000 in 2005 for retirement, and you've targeted an overall asset allocation of 70% stocks, 30% bonds. Let's also assume that you will furnish the maximum allowable to your 401(k); for 2005, that's $14,000, or $18,000 for workers age 50 and over. Your best bet would be to allocate the entire $6,000 bond stake to the 401(k). You should then devote any additional 401(k) contribution to stocks, filling out the rest of your equity allocation in taxable accounts.

When it comes to selecting the bonds for your 401(k), most pros advise that with interest rates ascending, you should stick to short- and intermediate-term issues, which suffer less damage than long-term bonds when rates rise. Treasury inflation-protected securities, or TIPS, are another good choice. Their principal increases along with the consumer price index, so returns should outstrip inflation. "I think inflation is a real risk in the next five years," says Robert Arnott, a money manager and editor of the Financial Analysts Journal. "If you have TIPS at your disposal, use them. If you don't, then stay relatively short in your bond portfolio."

Asset allocation isn't the only issue on experts' minds these days. Some are posing a more profound question, one that verges on apostasy. They're wondering whether you should funnel as much money as you can into your 401(k) each year. The conventional thinking has always been that not only does the 401(k) have the advantage of an immediate tax break (since your contributions are made in pretax dollars), but it also offers the potential for years of tax-deferred compounding. Over the long haul, FORTUNE and many others have argued, you'll save a bundle in taxes.

For most high-income households, that's still good advice. But if you're earning $100,000 or less, some think you should consider not contributing the maximum allowable--especially if you don't get a company match. "The 401(k) has the potential to be a tax trap," warns Laurence Kotlikoff, who chairs the economics department at Boston University.

The pitfall, explains Kotlikoff, is that future withdrawals--and remember, they're mandatory beginning at age 70--could trigger a big hit on your Social Security payments. Here's why: Once your income other than Social Security exceeds a threshold ($25,000 for single taxpayers or $32,000 for married couples filing jointly), from 50% to 85% of your Social Security benefits are subject to taxes. If you've saved a lot in your 401(k), in effect, the government punishes you by dinging your federal stipend. And the situation could get even worse if income tax rates rise in the future--something that seems likely, given the burgeoning deficit.

Research by Kotlikoff and Jagadeesh Gokhale, a senior fellow at the Cato Institute, indicates that to minimize their lifetime tax burden, most middle-class households should earmark only about 4% to 6% of their pay for their 401(k)s--and save far more in taxable accounts. But how the numbers shake out for you depends on circumstances such as age, income, outstanding home mortgage, and amounts already built up in taxable and retirement accounts. You can assess your situation using a software program developed by Kotlikoff and Gokhale (see www.esplanner.com; the program costs $149).

Still, nobody should drop out of his 401(k) plan altogether. If you receive a company match, always ante up as much as you need to get the full employer match. You'll never beat the return offered by free money. And don't underestimate the autopilot aspect of the 401(k), which makes saving much easier for most people--not to mention the fact that once the money is stashed in a retirement account, it's out of impulse-spending reach. Choosing to direct dollars otherwise slated for a 401(k) plan into a taxable account "can make sense for those with the discipline to follow through on it," says money manager Arnott. "The problem is, most people don't have the discipline."

Another alternative to topping out your 401(k) investment each year is this: After locking in a full 401(k) match, fund a Roth IRA to the maximum if you're eligible. Although you invest after-tax dollars in a Roth, the money is protected from the IRS while it grows, and your withdrawals also won't require a handout to Uncle Sam. For 2005, you can put up to $4,000 in a Roth, as long as your adjusted gross income is less than $110,000 ($160,000 for couples filing jointly). You can then continue to fund your 401(k).

If, by the way, you own company stock in your 401(k) and you're planning to leave your job, the recent tax cuts have added more appeal to an already nifty strategy. Most advisors have historically counseled that you roll the 401(k) into an IRA. But if the company stock in your 401(k) has appreciated, consider transferring it to a regular brokerage account instead of an IRA, says Ben Ledyard, a managing director at Wilmington Trust. Yes, you'll be taxed on the withdrawal and (if you're under 55) slapped with a 10% penalty. But the tax will be based on the cost basis of your shares, not their market value. And once the stock has been transferred to a taxable account, any future sales will be taxed at the 15% capital gains rate (assuming you hold the stock for at least a year). By contrast, if you were to transfer the stock into an IRA instead, the whole amount would be taxed at the much higher ordinary income rate when you withdraw it.

Over the coming months, you should also watch out for another development that could affect your savings strategy. Beginning in January 2006, the Roth 401(k) will be rolled out. The 2001 tax law allowed the creation of these accounts, which will let 401(k) participants make after-tax contributions to their plans. As with a Roth IRA, the earnings growth and withdrawals will be tax-free. You'll be able to contribute as much as you would to a regular 401(k) (for 2006, that's $15,000). Most important, there will be no income restrictions on who can contribute to the new plans. That said, employers will not be required to offer the Roth 401(k), so you'll need to contact your benefits department for more guidance. For a quiet investing year, it turns out, quite a bit has changed.