Four Ways to Make Your 401(k) Work Harder
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
The most common way Americans save for retirement is the 401(k), that do-it-yourself substitute for the old-fashioned pension enjoyed by your parents and perhaps your grandparents. Is yours working as hard for you as it could?
This week I’ll tell you four ways to harness the power of that retirement account. In my next few columns, I’ll give you a total of 21 ways to improve your financial future.
(If you’re doing all these things already, I bet you know a younger person who could benefit from this advice. I hope you’ll pass it along.)
My first suggestion will probably surprise you: Don’t invest much money, if any, in your 401(k).
No, that’s not a typo. Often, the 401(k) is not the best way to save for retirement—with one very important exception. That exception is the employer match. If your employer will match any part of your contributions, then you should do everything you can to maximize that benefit.
However, once you have tapped any available “free money” from your employer, you may be better off investing in an IRA instead of putting more into your 401(k). The most important advantage of an IRA is its better investment choices.
In a 401(k), your investments are limited to the options that were chosen by your plan’s administrator. Very few plans give you access to all the asset classes I recommend, and 401(k) investment options are often saddled with unnecessarily high expenses. In a follow-up column, I’ll list the important asset classes that every retirement plan should offer.
Second, I suggest you choose the Roth option, either for your IRA or (if your employer offers it) for your 401(k) . In a non-Roth (traditional) 401(k) or IRA, your contributions are deducted from your taxable income, so you pay no taxes on the money up front. After you retire, you pay taxes on every dollar that you take out.
In a Roth, you get no tax deduction for making contributions. But after you retire, every dollar you take out will be tax-free. Along the way, all your earnings will build up tax-free.
The mathematics of this choice aren’t immediately obvious, but it boils down to this: The Roth option effectively lets you contribute more to your retirement savings than the non-Roth.
The ultimate wisdom of this choice depends on your future tax bracket, which is impossible to predict. Nevertheless, if you can afford to pay the taxes upfront, your retirement savings will be worth more later.
The rules regarding IRA contributions can be complex. Some people have too much income to deduct an IRA contribution or to contribute to a Roth IRA. However, those people can still make a nondeductible contribution to a traditional IRA, then convert that traditional IRA to a Roth.
All that probably sounds like a lot of work. If so, you may like my third suggestion better: use target-date retirement funds , which are usually labeled with an expected retirement year.
If this is your choice, you’ll have lots of company. Vanguard reports that 82% of its employer retirement plans include these funds, and nearly one-quarter of participants invested only in a target-date fund.
If you aren’t confident of your ability to choose the best balance of stocks, bonds and cash, then use one of those target-date funds.
This way, you accept the professionals’ decisions about what is best for you. It’s not perfect, but it’s easy. And if you follow this route, you’re likely to avoid many of the worst mistakes that investors make.
These funds can be too conservative for younger investors and too aggressive for investors who are especially skittish.
Fortunately, there’s an easy fix for that. If you want a fund that’s more aggressive, choose one with a later retirement date; to get one that’s less aggressive, choose one with an earlier date.
My fourth point is related. If you’re willing to do a little work, I believe you can add an extra one to two percentage points a year to your return. Over a lifetime, that can essentially double the amount of money you have available when you retire.
How do you do this? Skip the target-date retirement funds and manage your own account . Target-date funds include bonds even for young investors who don’t need them, robbing these investors of growth they could otherwise have without providing any meaningful benefit.
When you manage your own account, you can dial in just the right level of bonds depending on your age and temperament. And on the all-important equity side of your portfolio, you can carefully choose asset classes that have long records of beating the Standard & Poor’s 500-stock Index with little or no extra risk.
In my next column I will introduce you to some of these asset classes and tell you how to find them in your 401(k) plan.
Richard Buck contributed to this report.