2010: Is your 401 o(k)?

Not long ago, retirement meant a nice gold watch and a monthly check providing for a modest, but comfortable lifestyle. Times have changed. The number of defined benefit (pension) plans has decreased from 150,000 to 50,000 between 1980-1999 (according to Benefits and Compensation Digest Vol. 43, No. 2 Feb. 2006).

It is more important than ever to take control of your own destiny; your own retirement. If you’re just entering the workforce or even mid career, your employer-sponsored 401(k) program will likely be your greatest source of retirement income; that is, if you fund it.

Staggeringly, Only 42% (less than half!)of all workers are currently saving for retirement and approximately 23% are counting on Social Security to be their largest income source upon retirement. (Employee Benefits Research Institute).

Free money – you know that warm, fuzzy feeling you get when you find a $20 bill on the sidewalk? Believe it or not, this investing stuff can be just as fun. Why not savor that same feeling every time you get paid? In many cases, your employer will match a portion of the investment you contribute to your plan, but only if you contribute. You owe it to yourself; to your future; to contribute at least enough to your plan to get the match.

Tax breaks – if you contribute to a traditional 401(k) plan, you’ll offset your income dollar for dollar (up to IRS limits of $16,500 for 2010 as well as an additional $5,500 for those age 50+). All the money you invest grows tax deferred until you take it out in retirement; thus affording you years of tax free growth to accumulate a substantial nest egg.

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Once you’re enrolled in your 401(k) (which is becoming automatic for new hires at many companies), it’s time to talk strategy. Don’t worry, it’s not that bad!

Assess your risk tolerance.

The younger you are, the more time you have to sustain market losses if and when they occur. On the flipside, the longer you have to make yourself a lot of money. Those who had the courage to continue to save through the depths of this last market downturn arguably saved what will be some of the most powerful money for their future retirement, as it was bought at such a significant discount. There are dozens of reputable finance and investment websites with articles on how to gauge your risk and what kind of portfolio to build (in a nutshell, they’ll help you decide how much risky stuff you should mix with the safer stuff). A well designed plan will give you just enough options, without too many to confuse the issue.

Limit company stock! I can’t emphasize this enough. A small portion of your employer’s stock can be appropriate, but limit exposure to 5% or less of your portfolio. You’ve got enough riding on your company already--your benefits, your healthcare, maybe a pension. Build a well diversified portfolio--check out money.com or motleyfool.com for some allocation tips. Some large companies, some small, some international, and so on. It can sometime seem boring, but it’s important to have enough of a mix that when some parts of the market head south, your whole portfolio doesn’t drop in unison. Discipline yourself to save and let the investments work for you.

Examine your account once or twice a year. Did you start out with 70% stocks and 30% bonds? If so, it’s possible that the stock market did well and a year later your portfolio actually consists of 80% stock and 20% bonds. Periodically rebalance your account. This means that you systematically re-adjust your account back to the initial mix you decided on when you did your risk assessment, thus making sure that you’re never taking too much risk for your situation. Keep in mind that as you get older, you’ll want to adapt your strategy to meet your decreased level of risk tolerance.

Keep contributing. And then contribute some more. Make it a goal to save 15-20% of your salary and over time, consider allocating merit pay increases straight toward this goal. This will allow you to continue to sock more away without affecting your take home pay and make your target more manageable.

When does it make sense to borrow?

It may sound intriguing to borrow from yourself and pay yourself interest. However, a credit line or a home equity loan often makes more sense. The problem with borrowing from your 401(k) is that, while the money is out of the plan it’s typically not growing (think flat screens or cars--our wants and desires are usually depreciating assets). In addition, if you leave an employer and still have an outstanding loan, you are typically forced to repay it all at once or face taking the balance as income for the year, along with a 10% penalty. That’s a pretty stiff ATM fee. Lastly, when you borrow from the plan, you typically repay with money after you’ve paid taxes. Then, at retirement, when you take the money out again, you’re taxed again. Doesn’t sound that intriguing anymore, does it? However, according to a 2007 study conducted by Ariel and Schwab, about 20% of investors have borrowed from their plan prior to age 59 ½.

Pros/Cons of Rolling Over Your 401(k)

If/when you leave your employer or retire, it’s important to maintain control of your hard earned (and hard saved) assets. You usually have several options. If you move to a new employer who also has a 401(k), you can combine your old plan along with the new one. Alternatively, if the new plan does not have as good of investment options, you can usually leave your old plan right where it is. Lastly, and usually the most flexible option, is to take your old 401(k) plan and roll it over to an Individual Retirement Account (IRA). Like the 401(k) plan, an IRA allows for tax-deferred growth, but also for nearly unlimited investment options versus a set menu of options through your employer. However, drawbacks can include high(er) fees, holding periods, a lack of ability to take loans or borrow from an IRA as well as less potential creditor protection.

It is extremely important to prioritize your goals and weigh all your options before rolling over your plan. Ask lots of questions, examine all fees and expenses, holding periods, etc…

It is important to understand that rolling your old 401(k) to a new employer or to an IRA is usually a tax free event, as you are continuing to defer the growth. However, it can be tempting to tap your nest egg to pay bills and buy toys between jobs. If you withdrawal the money for yourself, you will likely face a hefty tax bill and additional penalties for any early withdrawals. Resist the urge!

As mentioned above, it’s critical to examine the amount of risk you take and make sure it’s commensurate with your age and time until retirement. Make sure you’re taking the most efficient amount of risk to keep aligned with your goals because too much or too little risk could make or break your nest egg.

Also, examine all the features of your employer’s savings plan. The Roth 401(k) allows you to save on an after-tax basis, meaning you pay taxes now on your contribution, but the growth and the subsequent income you receive in retirement is free of tax liability. This contrasts with the traditional 401(k), which allows you to save on a tax deferred basis, potentially leaving you more in your wallet now, when you may need it more and paying taxes in retirement, when you may be in a lower tax bracket.

Final Thoughts

While it is important to save for retirement, it is also critical to have other, potentially more liquid savings. Consider establishing an emergency fund with 3-6 months living expenses in case of unforeseen events. Also, examine your debt load. If you’re racking up credit card debt just so you can contribute to your 401(k), you’re probably doing yourself a disservice. Prioritize and reduce high interest debt.

As social security and the pension plan join the likes of the gold watch and the Edsel, take time this coming year for yourself; to ensure that your future isn’t extinct before you get there. At the very least, make it a goal to begin saving. And if you need to, contact someone who can help.