The Last 401(k) Guide You'll Ever Need
Your 401(k): The Only Five Rules That Matter
(MONEY Magazine) – You know what's good for you: exercising regularly, eating a balanced diet, paying off your credit cards--and funding a 401(k) at work. You're probably already familiar with the wonders of the retirement plan with the name only a law clerk could love. For every dollar you set aside in a 401(k), you earn an instant tax break and, typically, a 50¢ matching contribution from your employer. That's a 50% return, guaranteed, with no taxes due on your earnings until you withdraw the money. All in all, there's no better way to secure a prosperous retirement.
Now there's a hard way and an easy way to manage this asset. If you were so inclined, you could make running your 401(k) as complex as overseeing Harvard's endowment. You could spend hours fretting over investment choices, monitoring your balance daily, if not hourly, and hoping to divine which fund will be the biggest gainer. You could do that. Or you could stick to a few principles that will keep you out of trouble and, with much less stress, provide just about the same return as the obsessive approach. Volumes have been written--in this magazine and elsewhere--about the fine points of managing a 401(k) plan. But all the knowledge you need boils down to five simple rules. Get them right and this could be the last article you need to read about 401(k)s.
1 Save early and often The most important part of 401(k) investing is also the easiest to master: It's the act of saving regularly. You may think 401(k) success is all about selecting funds with hot performance. In reality, how much you save matters far more than what your funds return. Suppose you started work in 1990 with a $40,000 salary. You saved just 2% of your pay but were such a brilliant investor that you put your 401(k) into top-returning funds every year. You would have finished 2005 with nearly $50,000 in your 401(k). Now suppose you were so clueless about investing that you picked mediocre funds year after year, but you were frugal enough to save a full 6% of salary. You'd hit 2005 with nearly $120,000. That's right: more than twice as much as the brilliant saver.
A growing number of employers will automatically sign you up for the company's 401(k), as well as regularly increase your contribution rate, making saving literally effortless. Problem is, these automatic investments often start at just 2% to 3% of your salary. Not enough. If you're in your twenties, suggests Christian Echavarria, founder and senior vice president of Invesmart, a 401(k) advisory firm, figure on putting away at least 6% of your salary, or 10% if your employer doesn't match your savings. Then increase your contribution by as much as one percentage point a year. In your thirties, you should be saving 12%; in your forties, 14%. By the time you reach your fifties, you may need to save 15% or more, depending on how much ground you have to make up. It helps that by age 50 you can contribute an extra $5,000 a year on top of the regular 401(k) max (for a total of $20,000 in 2006). To figure out a more precise contribution goal, use the 401(k) planning tool in the Calculators section of Bankrate.com.
2 Spread your money around However much you save, of course, you still want to make sure that you're smart about your investments. That doesn't mean you have to be the next Warren Buffett. What you must do, though, is choose a suitable combination of stock funds, bond funds and other investments. The idea is to create a blend of assets that's aggressive enough to improve your odds of earning the returns you need, but not so risky that you'll panic during market downturns and bail out. The sample portfolios on page S4 show how you might strike that delicate balance at different ages.
This may sound difficult in its own right, but most 401(k)s offer a simple and perfectly prudent solution: a target-date retirement fund. These funds, which invest in stocks, bonds and other assets, create a portfolio geared to someone who plans to retire in a particular "target" year. Just pick the fund whose target is closest to your desired retirement date. (One tip: Don't mess up your allocation by investing in other funds too.)
If you prefer a more tailored mix, click on the Asset Allocator tool at cnnmoney.com/allocator and answer the questions about your time horizon and tolerance for risk. Once you and the computer settle on a portfolio, you'll need to select stock and bond funds to fill it. Just remember one simple rule: Stick with low-cost funds, which let you keep more of the returns. How can you tell which funds in your 401(k) are low cost? Many large-company plans offer funds that mimic market indexes (look for the word "index" or the name of an index like the S&P 500 in the fund's name); expenses often run less than 0.3% of assets a year. If you can't fill your portfolio with indexers, look for choices that have generic names such as Small-Cap Value or Large-Cap Growth. These institutional funds also generally have modest fees--say, 0.7% of assets for stock funds. In any event, stick with stock funds that charge less than 1% and bond funds with fees under 0.5%. Your plan's administrator can tell you each fund's expense ratio.
3 Limit company stock You may have full confidence in your company's future, but when it comes to your 401(k) strategy, nothing can trip you up more than blind loyalty. Never put more than 10% of your money in your employer's stock. After all, your job security already depends on your firm's financial health. If you load your 401(k) with your company stock, you are wagering your retirement security on your employer as well. Yes, if the stock soars, you'll do better than if you had spread your money around. But as the table below shows, the risk isn't worth it.
4 Check in once a year When you've got your plan in gear, you really can relax. All you need to do is minor maintenance one day a year. Pick any day for this checkup: a week after your birthday, the day after New Year's, whatever.
Start by revisiting your asset mix. If market downturns have been giving you sleepless nights, you may have taken on too much risk. Consider shifting to a more conservative asset mix by moving money from stock funds to bond funds. Playing it safer is something you should do anyway as you get closer to retirement; you can't afford to be caught by a market slump that near the finish line.
If you have a do-it-yourself portfolio rather than a target-date fund, this checkup date is the time to rebalance. In other words, it's time to correct for the fact that during the year, gains in some funds and losses in others throw your asset mix out of whack. Compare your current allocations with your targets. If they are off by, say, 10% or more, transfer enough money out of your winners into your losers to get back to your original mix. By doing this every year, you force yourself to sell high and buy low--the very definition of smart investing. In most plans, you can rebalance with one phone call to your 401(k) provider or with an online tool. And, of course, if you hold a target-date fund, you're off the hook: All this is done for you.
Ignoring your 401(k) for 11 months and 29 days every year may seem like slacking off, but it's far, far better than tracking your returns too closely. Obsessing over performance could entice you into the classic mistake of chasing yesterday's winners. Benefits consultant Hewitt Associates found that in 2005 many 401(k) investors loaded up on emerging markets funds, which had been delivering double-digit returns. But in May of this year, foreign markets tanked, and panicked investors found themselves selling with 20% losses. "When you chase the highest-returning funds, you often end up selling at the bottom," says Lori Lucas, Hewitt's director of participant research. That's why you want to pick an asset mix (or target fund) that you can stick with through market gyrations.
5 Keep your hands off The final 401(k) rule to live by is this: Don't touch the money when you change jobs. The worst mistake you can make is to cash out. Not only will you end up losing much of your savings to taxes and penalties (see the box below), but you'll also set back your retirement savings. Instead, pick one of these three options.
SUPER-EASY: ROLL THE MONEY OVER INTO YOUR NEW 401(K) Do this if you like your new plan's low costs and its investment options--and you like having all your retirement money under one roof. (You should: It's easier to manage.) What to do: Contact your old benefits department and the new one, and sign the paperwork.
ALMOST AS EASY: STAY WITH YOUR OLD 401(K) Go with this option if you like the funds you already picked and are confident you can keep tabs on a 401(k) at a place you don't work anymore. to do: Let your HR department know you plan to leave your account behind. (If you have less than $5,000 in it, though, your employer can push you out.)
MEDIUM EASY: ROLL OVER INTO AN IRA Choose this option if you like the freedom to invest with nearly any fund company, bank or brokerage, and if you don't mind tracking both the IRA and the 401(k) that you'll open at your new employer. What to do: Call the company of your choice, and then sit back. Most major firms will do the paperwork and make all the phone calls. Really. It's that easy.
The trouble with company stock
You may be tempted to bet heavily on your own employer. Before you do, consider the steep risks. Here's what could happen to your plan if you're 35, earn $50,000 a year and already have $50,000 in your 401(k).
NOTES: Annual 401(k) contribution equals 9% of salary, which increases at inflation plus 1.5 percentage points. Company stock is a growth stock; diversified portfolio is a blend of domestic and foreign stocks and bonds. SOURCE: Financial Engines.
The high cost of cashing out If you leave a job with $50,000 in your 401(k) and...
NOTE: IRA total is in today's dollars. SOURCE: Vanguard.
Why try harder?
• $60,000 starting salary
• 3% annual raise
• 50% mach
• 8% annual return
• 30-year time span
...and contribute this much of your salary...
9% $1.1 million
...and you'll end up with...
NOTE: Match ends at 6%.
Pick Your Mix
If you're far from retirement, go with the aggressive portfolio below left, which is dominated by large, small and international stock funds. Mid-career, a more moderate combination of stock and intermediate-term bond funds is a more sensible investment choice.
Large caps 35%
Mid caps 13%
Small caps 12%
More than 20 years from retirement
Large caps 27%
Mid caps 7%
Small caps 6%
Real estate 10%
10 to 20 years from retirement