Over the past few years, the 401(k) and its sister plan, the 403(b), have become more user-friendly and potentially less risky. By taking advantage of those changes, you can maximize your returns on those workplace retirement accounts. Click through to see the five steps you should take now to get the most from your 401(k).
Chances are, high fees are putting a bigger dent in your 401(k) return than you realize. Yale professor Ian Ayres has been stirring up a lot of controversy recently, arguing that fees charged in 401(k) plans are so onerous that the damage they do to your return could outweigh the tax benefits they offer.
Even a seemingly small difference in fees can have a significant impact. A $25,000 investment growing at an average 7 percent annually with fees of 0.5 percent increases to $227,000 over 35 years, even with no additional contributions. With annual fees of 1.5 percent, that nest egg is only $163,000. A 2012 study by the progressive think tank Demos estimated that two median-income earners could pay, on average, almost $155,000 in 401(k) fees over a lifetime.
You can do your own detective work to find out the fees you are paying. Since 2012, participants in 401(k)s have been able to see more clearly how much they are paying for the management and administration of their plans and funds. Mandatory annual plan-fee disclosures sent in August show how much you paid in fees for every $1,000 invested. Quarterly statements detail those fees and expenses.
If you’re not happy with the fees your disclosure shows, search for other options within your plan. Go to Morningstar and type the ticker symbol of the fund you’d like to replace in the search box. Morningstar will identify the kind of fund, such as small-cap value or large-cap blend, and compare the fund’s performance to a benchmark. You can then plug in the names of other funds in your plan to find comparable options. (Morningstar’s pay service, which has more comparison tools, is free for a two-week trial; subscriptions start at $195 per year or $23 per month.)
Another tool, the Financial Industry Regulatory Authority’s free Fund Analyzer, shows the lowest-cost option among three funds of your choosing. To get your results, you’ll need to input the funds’ ticker symbols and estimated returns, and your expected investment period.
As a general rule of thumb, you shouldn’t pay more than 1 percent of assets for any one holding in a 401(k), especially if you work for a very large company with the muscle to negotiate provider fees. If your disclosure shows otherwise, it might be time to push for an overhaul of the fund lineup or even a change in providers. Toward that end, check out Brightscope, which uses IRS information to rate 401(k) plans on factors including total cost and generosity of the company match. It shows how your plan stacks up against plans from similar employers and against all 401(k) plans. (For a more detailed report, you’ll have to pay $100 and get access permission from your plan’s fiduciary; contact BrightScope for details.)
The Roth 401(k), permitted by the IRS in 2006, has become more prevalent. It’s targeted to younger and lower-paid workers, but others might also benefit from using it.
For those who are subject to relatively low tax rates now, the benefits are obvious. By paying tax now on their Roth contributions, they enjoy tax-free growth and withdrawals forever after. Higher-paid workers who can’t contribute to Roth IRAs because of income restrictions can invest in Roth 401(k)s.
Another potential benefit is that once you roll the balances over into a Roth IRA, the funds are no longer counted in determining required minimum distributions that you must take starting at age 70½, according to Scott Michael, a certified financial planner and partner at ParenteBeard Wealth Management in York, Pa. Certain companies allow participants who are still employees to roll over Roth 401(k)s into Roth IRAs starting at age 59½, a move called an in-service, nonhardship withdrawal distribution.
That last fact could make a Roth 401(k) investment worthwhile even for middle-income savers. The less you’re required to withdraw, the less tax you’ll pay in retirement. At the least, it allows for more flexible planning, says David Walters, a certified financial planner and certified public accountant at Palisades Hudson Financial Group in Portland, Ore. “We call it tax diversification,” he says.
The closer you are to retirement or semi-retirement, the more easily you can predict your income and determine which 401(k) type should receive your contributions. In theory, you should invest in a Roth if you expect your tax rate to be higher in retirement. Keep in mind that your current effective tax rate—the percentage of your income paid in tax after credits, deductions, and exemptions—might be lower than your paycheck suggests. If you now claim lots of deductions, such as mortgage interest, you might need the Roth’s tax hedge in retirement when those write-offs wane.
Caveat: If only your traditional 401(k) offers a company match, fund it first, at least to the limit required to receive the maximum match.
Fifty-six percent of employees reported that their employers automatically enroll them in their 401(k) plans, usually at a contribution rate of 3 percent, according to a 2013 report by the trade organizations WorldatWork and the American Benefits Institute. Auto-enrollment, first sanctioned by the IRS in 1998, can help launch younger workers, or anyone with inertia, on a retirement-savings trajectory. Studies show that those enrolled that way usually don’t opt out later.
Plans also may include an automatic step-up option, bumping up an employee’s contribution each year until it hits an established limit. Some employees don’t bother to up their antes beyond the initial amount. So if you haven’t done so already, ramp up your investment now. Financial advisers recommend deferring at least 10 percent of your income into your 401(k), increasing your contribution whenever your salary rises.
Years ago, many 401(k) sponsors offered little or no guidance to employees on where to invest their funds. Today, undecided investors are often placed automatically in target-date or “lifestyle” retirement funds, essentially a mix of investments that rebalances on its own. The proportions of stock and bond holdings within such funds vary depending on the investor’s expected retirement date. The mix slowly shifts toward bonds as the investor ages.
If you find it difficult to channel your inner Warren Buffett, those autopilot options can be decent choices. A 2013 Morningstar survey noted that although the asset allocations of such funds varied somewhat by company, most should deliver similar results that are expected to sufficiently support retiree spending to age 85.
You’ll get the best bang for your buck when the component funds are low-cost indexes. But if the expense ratio of available target-date funds your company offers is higher than that of a diversified basket of other options, you’re better off cobbling together a mix of other, lower-cost funds and rebalancing them yourself.
The most common employer 401(k) match is 100 percent on the first 6 percent of salary contributed, according to a report issued late last year by benefits consultancy Aon Hewitt. That dollar-for-dollar gift is the first change in the match that Hewitt has observed in 20 years. Regardless of how generous your employer match is, you need to make sure that you contribute enough to get the maximum contribution. Otherwise you really are missing out on essentially free money.
Participants who are 50 or older and who can afford to make the extra $5,500 in catch-up contributions can jump-start their savings significantly, even if they’ve been remiss in the past. A worker contributing the maximum $23,500 each year from ages 50 through 55 would have about $342,000 more in his or her portfolio by age 67, given an average 6 percent annual rate of return.
Maxing out on your 401(k) rather than relying on outside investments can provide advantages beyond a cut in current income taxes. For instance, college financial-aid formulas generally don’t consider parents’ retirement investments. So stashing your cash in a 401(k) could mean more aid for your kids. If your state offers tax credits for investing in a 529 education plan, you might be better off putting your after-tax money there instead. The higher your household income and assets, the greater the likelihood that you’ll benefit more from that bird in the hand.
About three-quarters of employers offer 401(k) participants some form of investment advice, according to Aon Hewitt. No doubt many have been inspired by a 2011 Department of Labor rule that clarified allowable 401(k) advice. The range of information provided is wide. Your 401(k)’s services could be as impersonal as an online interactive worksheet or as intimate as a one-on-one relationship with a certified financial planner.
The NetBenefits site for participants in plans managed by Fidelity Investments, for instance, helps employees determine how much money they’ll need in retirement and how much they’ll have at various future dates. The service provides useful features such as calculating how your take-home pay grows or shrinks as you change your contributions.
At Vanguard, depending on the service your employer selects, you could have access to Financial Engines, an independent retirement planning tool. If an employer chooses, Vanguard offers participants 55 and older a free retirement plan prepared by a certified financial planner, with regular follow-up phone calls.
Many employees ignore those valuable planning tools. Only 15 percent of eligible participants use the advice services their employers provide, but those who do report greater confidence in their retirement plans, according to a 2013 report by Mercer, a benefits consulting firm. The results of those advisory tools can be inexact or incomplete, but taking advantage of such advice can help jump-start your retirement planning. $
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