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5 New ways to plan for it
Major changes are on the way to protect your 401(k) -- from you.
October 11, 2005: 8:05 AM EDT
By Penelope Wang, MONEY Magazine
The dream retirement

MONEY's best places to retire
Comparing your saving options
You must earn less than No limit No limit $160,0001
The most you can save2 $15,000 $15,000 $4,000
Up-front tax break? Yes No No
Withdrawals taxed? Yes No No
Mandatory withdrawals? Yes,
70 1/2
Yes* No
*Avoid by rolling over to a Roth IRA
Notes: 1Modified adjusted gross income for married couples filing jointly; $110,000 for singles. 2For 2006; people 50 and older can contribute another $5,000 to a 401(k) and another $1,000 to an IRA. Contribution limits are for both types of 401(k)s combined.

NEW YORK (MONEY Magazine) - Want to know what the biggest problem is with your 401(k)? Look in the mirror. It's you. At least that's the assumption -- that too many people sabotage their 401(k)s with their own behavior -- behind many of the new features you're likely to see over the next few years.

Even if your investing behavior needs no improvement, the trends in 401(k)s can still be useful for you. In some cases they can make it much easier for you to invest your 401(k) money. In others they may provide opportunities you never had in your plan before, such as converting your 401(k) stash into a guaranteed lifetime income.

Exactly what sort of "bad behavior" are 401(k) sponsors worried about?

To begin with, fewer than one out of three people eligible for a 401(k) even bother to join the plan, although most of them are effectively turning away free money in the form of employer matching contributions. And those who do sign up usually don't save nearly enough to create an adequate nest egg. Only 8.4 percent of 401(k) participants sock away the max.

When it comes to investing, well, dubious decisions abound there too. Despite the lesson of Enron, many people continue to plow too much of their money into company stock, which still accounts for a whopping 25 percent of assets in plans that offer it. As for tending 401(k) portfolios, not-so-benign neglect seems to be the rule. Fewer than one in six participants make any transfers from one fund to another in a given year, which means a tiny minority at best is performing even routine maintenance such as rebalancing their portfolio annually.

The reason so many workers do a lousy job overseeing their 401(k) isn't that they're incompetent. It's that they never set out to be investment managers in the first place. It's hard enough managing a career and taking care of a family. Who has time to monitor an investment portfolio too?

"We've tried to turn a nation of noninvestors into pros, but it hasn't worked," says Alicia Munnell, director of the Boston College Center for Retirement Research and co-author of "Coming Up Short: The Challenge of 401(k) Plans." "Most people let inertia take over their accounts."

Making 401(k)s foolproof

Faced with that reality, more employers are trying another approach: Filling 401(k)s with features that essentially make key decisions for you.

For example, a growing number of plans will automatically enroll you in your 401(k) as soon as you're hired unless you specifically opt out. Many offer a program that will gradually boost your contributions according to a preset schedule -- say, an extra 1 percent of your salary every year, until you hit the maximum. This prevents you from languishing at a low contribution rate even as your income grows and you can afford to save more.

Help is also on the way on the investing front. Overwhelmed by the panoply of investment options in your 401(k)? No problem. Many plans allow you to direct money to a target-date fund, or life-cycle portfolio, a new breed of mutual fund that gives you a diversified mix of stocks and bonds geared toward your expected retirement date. Or you might have the choice of turning over your account to an independent financial adviser who will custom-tailor a portfolio for you.

When you're finally closing in on retirement, some plans will help you convert your account balance into a monthly income that will last the rest of your life, in effect providing the equivalent of a traditional pension.

"We're attempting to create a 401(k) plan that would even work for Rip Van Winkle," says Steve Deschenes, executive vice president of Fidelity's retirement services. "The goal is to allow you to wake up in 40 years and still afford to retire."

Snooze vs. choose

If you don't have the time to stay on top of your plan or you just don't want to be bothered, the do-it-for-you 401(k) certainly makes a lot more sense than haphazardly choosing whatever investment happens to look good at the time. And it definitely beats not taking part in your plan at all.

But remember: No one is suggesting that it's better to snooze your way to retirement. These services are purely voluntary. You always have the option of taking a more active role in your 401(k).

And, indeed, if you're willing to put in just a modest amount of effort and follow the investing strategy outlined here, you should be able to parlay your 401(k) savings into a tidy retirement nest egg that can help support you throughout retirement.

But even if you choose to remain the master of your 401(k) domain, you should still take a look at these new features if your plan offers them. In some cases, for example, your plan may be able to provide investment advice on retirement assets you hold outside your 401(k) at a lower cost than you would pay a financial adviser for the same service.

Bottom line: Keep up with changes in your plan. At the very least, you may be pleasantly surprised by how it has improved.

And one more thing: Is a Roth IRA in your future?

Starting next year, you may have the chance to earn tax-free returns on the money you invest through your 401(k).

Thanks to a provision in a tax bill that most people have long forgotten -- does the Economic Growth and Tax Relief Reconciliation Act of 2001 ring a bell? -- your 401(k) may give you the chance to contribute to a new type of account starting next year: the Roth 401(k).

Unlike with a regular 401(k), you pay tax on the money you contribute. But come retirement time, withdrawals are tax-free, as they are with a Roth IRA. (See the table.)

At this point, only a handful of 401(k) plans are expected to have these accounts up and running in January. But since more companies are expected to offer them in the years ahead, it's a good idea to think ahead about whether this new option is right for you.

Generally, you should consider a Roth 401(k) if...

...You want to save more for retirement

If you put $15,000 into a regular 401(k) next year (the maximum that will be allowed), you haven't really saved that whole amount for your use in retirement. That's because you'll still have to pay income tax on the money and on your investment earnings as you make withdrawals.

With a Roth 401(k), however, since you've given up the tax deferral and paid your tax bill up front, the entire Roth 401(k) balance will be available for you to spend in retirement.

...You expect to be in a higher tax bracket when you retire

A Roth 401(k) is a better deal than a regular 401(k) if tax rates rise between the time you contribute and when you pull the money out. The reason is that you'll have paid tax on your contribution when rates were low and avoided a higher tax rate later on, in effect protecting yourself from rising taxes.

...You want more flexibility in retirement

Fact is, we don't know what income tax rates will be in the future. But by stashing money both in tax-deferred accounts like regular 401(k)s and IRAs and in tax-free accounts like the Roth 401(k) and Roth IRA, you'll have more control over how much tax you pay each year when you start taking withdrawals in retirement.


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For more on MONEY Magazine's special report, The Dream Retirement, click here.  Top of page

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