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The 401(k) solution
Love it. Hate it. Rename it. Get used to it. The 401(k) remains the cornerstone of retirement.
April 27, 2005: 12:16 PM EDT
By Penelope Wang, Money Magazine
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NEW YORK (Money Magazine) - Could the plight of the retirement investor get any worse? The once-vaunted 401(k) has disappointed the millions of participants who've watched their retirement dreams shrink right along with their plan balances.

As the economy remains stalled and the nation is in the midst of war, the bear market continues to decimate portfolios. Now President Bush has proposed radical tax cuts, including dividend-tax breaks and expanded tax-free savings options, that could make the case for investing in a 401(k) less clear-cut. But those proposals may never be enacted.

Meanwhile, you've got to rebuild your nest egg. What to do?

For starters, keep in mind that over some 30 years of retirement investing, you'll ride out at least half a dozen presidential administrations, numerous economic cycles and, inevitably, hundreds of tax-law changes. The only way to avoid getting thrown off course by passing political debates or economic upheavals is to focus on what's most important: putting away enough money and maintaining the right asset mix.

At the very least, though, Bush's proposals should give your retirement strategy a new urgency. After all, by calling for investment tax breaks -- rather than proposing to strengthen Social Security or to beef up traditional corporate pension plans -- the White House has made it clearer than ever that achieving financial security is your responsibility.

Moreover, Bush's bid to create new savings accounts underscores the fact that you cannot rely on your company plan alone to fund your retirement. Part of the solution to rehabilitating your battered 401(k) may be to depend on it less.

That's where this article comes in. We've come up with five key principles for designing a long-term investing plan, both inside and outside your 401(k), and keeping it on track, no matter what happens to the market or in Washington.

1. Don't count on a single retirement plan.

When did you last sit down and calculate how much money you'll really need for a comfortable retirement? Did you just figure that maxing out your 401(k) was enough? The truth is, for many investors contribution limits make it impossible to save enough in a 401(k).

You may not have realized that you were falling short because you never devised a savings goal in the first place. Or you took false comfort in simple math and a blip in history.

"The retirement calculators that let you plug in a single average rate of return on your investments can be very misleading," says Debra Morrison, a financial adviser at Regent Atlantic Capital in Chatham, N.J. If you assumed a perpetual 15 percent return in the 1990s, for example, the bear market was a rude awakening.

To come up with a realistic goal, use a more sophisticated probability calculator. Rather than assuming that you will earn a single average rate of return for the next 30 years, this type of calculator stress-tests your portfolio against numerous economic scenarios to determine the odds that you will meet your goals.

By fine-tuning variables such as your savings rate, level of investment risk and retirement date, you can determine what it will take to avoid outliving your money. CNN/Money has some useful tools, as do many 401(k) providers, including Fidelity, T. Rowe Price and Vanguard.

You may be startled by the results. Take a 45-year-old earning $100,000 who has already accumulated a $300,000 nest egg. According to calculations by Financial Engines, which provides investment advice to 401(k) plans, if this person saved only the maximum allowed in a 401(k), or 12 percent of salary, for the next 20 years, the chances of retiring with 80 percent of income at age 65 would be only 70 percent, assuming full Social Security payments.

But by boosting the savings rate to 17 percent, he or she would have an 83 percent chance of retiring at age 65 with 80 percent of income. That means tucking away another 5 percent of pay outside a 401(k).

If you're 50 or older, you have an opportunity to make so-called catch-up contributions to your company plan (if your employer lets you -- most do). You can put an extra $2,000 into a 401(k) in 2003, $3,000 in 2004 and $5,000 in 2006. In addition, 50-plus investors who are eligible may put an extra $500 into a traditional or Roth IRA this year, an amount that rises to $1,000 in 2006.

2. Diversify -- it's still the key.

Next to your savings rate, your asset allocation is the most crucial element of your retirement strategy -- and the rules of diversification do not change with the tax law. The overall amounts you hold in stocks and bonds have a bigger impact on your return than your investment choices do.

Diversification also dampens your risk. Holding bonds as well as stocks helped the average 401(k) participant at Vanguard limit losses to 6.3 percent a year over the past three years vs. an annualized 14.6 percent loss for the S&P 500.

In general, 401(k) investors are a passive bunch, seldom adjusting their allocations or their investment choices. In recent years, Vanguard has found that some 85 percent of investors in the plans that it runs never trade. Investors have held on to stocks -- 71 percent of new 401(k) money at Vanguard goes into equities -- but too often by default.

While it's great that investors haven't cut and run during the bear market, there are problems with inertia. For starters, you need to rebalance periodically to maintain your allocations. That way, you automatically buy low and sell high. By failing to do so, you end up taking unnecessary losses when the market falls.

Like many investors, you may have loaded up on stocks in the 1990s -- the typical 401(k) equity stake stands at 65 percent -- only to regret that decision. But don't back away from stocks completely.

"Since the bear market, stocks have actually become less risky than before, when they were trading at very high prices," says Scott Lummer, a pension investment consultant in Santa Rosa, Calif. Over a 20- to 25-year investment cycle, stocks are still likely to return 8 to 10 percent a year.

Adds Lummer, "For long-term investors, if stocks outpace bonds by only 1 percent each year for the next 20 years -- and remember, they have typically beat bonds by five percentage points -- you will more than make up for your losses in the bear market."

Inertia has also left many 401(k) investors undiversified within asset classes -- most hold only three funds, typically a stock fund, an employer stock fund and a stable-value fund (see more on these new investments).

Make sure your 401(k) is spread among large and small companies, as well as foreign equities, and keep a healthy percentage in fixed-income assets, especially as you near retirement and have little time to make up for stock losses.

Stick to short-and intermediate-term bonds for maximum safety; those issues will hold up better than long-term bonds if rates rise. Also, consider your entire investment portfolio in your allocations, including investments outside of retirement plans.

Finally -- as if you need another reminder -- never forget that the riskiest asset of all is your employer's stock. Don't put more than 10 percent or so of your 401(k) money in it. Last year, Congress considered but failed to pass legislation limiting the amount that could be held in company stock; a Bush proposal to allow investors to sell matching contributions in company stock immediately may be reintroduced this year. Fortunately, many companies, including ChevronTexaco, Disney, AOL Time Warner and Gillette, have liberalized employer stock rules on their own.

3. Make the most of a 401(k)'s free money.

The 401(k) company match is one unbeatable retirement savings perk that doesn't look to be going away soon -- more than 80 percent of 401(k) plans offer a match, typically 50 cents on the dollar.

No tax cut will give you a better deal than an instant 50 percent return. While a few troubled companies have dropped their matches, those appear to be isolated cases. Under Bush's economic plan, the 401(k) would be renamed the Employer Retirement Savings Account (ERSA) but would still include a match. Other defined-contribution plans, such as 403(b)s for nonprofits and 457s for government employees, which typically do not offer a match, would no longer take contributions. Employers would probably convert those plans to ERSAs, most likely without a match.

One tip for anyone who's a so-called highly compensated 401(k) employee (under current IRS rules, that means those earning $90,000 or more): If your contribution rate is too high, you may not receive your entire match. That's because IRS antidiscrimination rules, which are aimed at preventing plans from being run mainly for the benefit of top executives, limit the dollar amount that highly paid workers can contribute.

If you receive a portion of your match with each paycheck, you might hit that dollar limit before the end of the year and find your contributions -- and match -- cut off. Check with your benefits office to find out if you need to lower your contributions to avoid missing out on the entire match.

Under the Bush tax proposals, antidiscrimination rules would be relaxed, allowing highly paid employees to put more money into their plans, but that would probably not affect this year's contributions.

4. Diversify for tax purposes, too.

The very tax features that make 401(k)s so attractive also bolster the case for investing outside of them. Here's why: With 401(k)s, you put in pretax dollars and the earnings compound tax-free until withdrawal, when the money is taxed at ordinary income tax rates.

The same would be true for the proposed ERSA. The problem is, your tax rate may be higher in retirement than it is now -- another President could raise taxes, not lower them -- which would erase much of the advantage of the tax deferral. And if you fill your 401(k) with stocks, you'll miss out on the lower capital-gains rate when you sell.

The elimination of the tax on dividends would further penalize 401(k)s, as well as traditional IRAs. In fact, if Bush's full tax plan picks up political steam later this year and becomes law, 401(k)s could lose even more of their luster because you'd be able to stash away more dollars completely tax-free in new savings accounts, with no income caps.

Even today, says Boston University economics professor Laurence Kotlikoff, who has co-authored studies on 401(k)s and taxes, "for some households, it may be better to pay taxes now than to defer them."

One reason is that when you withdraw money from a 401(k), the entire amount is taxable income. With a taxable portfolio of funds, you've been paying taxes on distributions all along, which reduces your taxable income when you sell. So 401(k) withdrawals can inflate your income so much that you end up paying higher taxes on your Social Security benefits.

Unfortunately, since it's impossible for most of us to predict future tax rates, there's no single ideal tax strategy. "You have to consider not only federal taxes, but state and local taxes, not to mention Social Security," says Francis Kinniry, an investing principal at Vanguard. "The only solution to the tax dilemma is to use tax diversification by investing both inside and outside your 401(k)."

Here's one sound tax hedge: After locking in a full 401(k) match, fund a Roth IRA to the maximum if you're eligible -- as much as $3,000 this year and up to $5,000 in 2008. (Married couples filing jointly can contribute the full amount if their adjusted gross income is under $150,000.)

Although you invest after-tax dollars in a Roth, the money grows tax-free and your withdrawals are tax-free. In the long run, a Roth and a 401(k) leave you with the same amount of money, assuming identical returns and no change in your tax rate. Plus, a Roth has no minimum distribution rules. If you still need to save more, your next dollars should go into tax-efficient investments such as index funds or into your 401(k).

5. Avoid needlessly locking up your money.

Up to this point, our advice has been to stick to your savings strategy -- and step it up. But here's one exception: Think twice about putting money in a variable annuity. With this investment, you stash away after-tax dollars and your money grows tax deferred until it is withdrawn, when it's taxed as ordinary income.

That trade-off may no longer be worthwhile under the Bush proposals. "If the dividend tax break is enacted, you may be better off keeping your money in a taxable account," says Mari Adam, a financial adviser in Boca Raton, Fla. "And if the tax-free savings accounts become available, there would be little reason to choose a tax-deferred account instead."

These caveats also apply to nondeductible IRAs. But the Bush proposals would make it relatively easy to switch your IRA to the new accounts. With variable annuities, you may have to pay costly surrender charges if you decide to pull your money out.  Top of page