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Being Smart About Your 401(k)
September 1st, 2010
With Social Security dwindling, it is as important as ever to be saving for retirement. An increasing number of companies are switching from lifetime pensions to 401(k)’s, transferring the responsibilities of your financial future to you. While there are problems with 401(k) plans, they are your best option at the moment for being able to retire comfortably. Many people, however, are still not educating themselves on the process, and are, thus, losing out on free money. If your company offers its employees 401(k) plans, take advantage of it! Here are 6 steps to protect your financial nest egg.
Once upon a time, employers used to automatically enroll hires into lifetime pension plans, but in recent times, that process has almost completely diminished. Whereas pensions provided retirees with monthly checks and forced the employer to take responsibility for saving, 401(k)’s allow the employees to manage their funds.
While this may appear intimidating for those who know little about financial processes, the least one could do is invest enough in a 401(k) to lock down the full company match. A typical structure is an employer providing a 50% match of 6% of employee contribution. For example, if John makes an annual salary of $100,000, then he should put $6,000/year into his 401(k) to receive the full employer match of $3,000. Any amount above $6,000 will not be matched by his company.
Another great benefit is the tax advantage you receive as part of the 401(k) plan. Until you start withdrawing from the account, dividends, interest, and capital gains can compound tax-deferred. If you start investing young, this can translate to significant savings over time.
Those who are engaged in a retirement plan are much more likely to actively manage their savings and be better prepared for their retirement. Due to the miracle of compounding interest, investing in a 401(k) starting in your twenties versus your forties can mean the difference between tens if not hundreds of thousands of dollars.
Coming out of the recent recession, many people have a deep mistrust of the financial system. Young professionals are putting more money into money market funds and bonds than in stocks, yet this can only harm them in the future. If you are in your twenties, at least 80 – 100% of your investments should be in diversified equities. As the decades pass, then you can start reallocating.
The Enron fiasco teaches us all a lesson about investing too heavily in one company. After its 2001 implosion, many of its employees’ retirement savings disappeared along with it, yet people continue to make the same mistake. If company shares are an option in your plan, be sure not to invest over 5% of your money in it. The recession brilliantly illustrates that companies are not invincible, even the largest of them.
If you have not updated your 401(k) contributions or investment allocation lately, get to it. Many people fail to adjust their contribution as their income increases and bonuses roll in. A promotion is a perfect time to boost your investments because while you are reevaluating your salary, you can also take another look at your retirement plan. Generally, you would be able to afford to put in a couple more percentage points and still walk away with more money in the paycheck.
There are plenty of reasons why people withdraw from their 401(k) savings before they reach retirement, but it is a big mistake to do so. Taking an immediate payout results in taxation on the money, an early-withdrawal fee, and depletion of your retirement funds.
When switching jobs, you do not need to cash out from your 401(k). Instead, leak the money over into your new 401(k) or IRA account. When you are low on cash, it may be very tempting to dip into your retirement account, but if you can resist that urge, it will benefit you greatly in the future. Do not be an emotional investor as Chicago financial planner, Chris Long states, “To be a good investor, you cannot make short-term decisions for long-term money.” During the recession, people began ducking out of their 401(k)’s because of market fear, but those who stayed earned an average of 7.2% return from 2003-2008. Base your decisions on logic and you will be a smart investor.
5. Target-Date Funds
If you are new to investing or are unsure of how to allocate your money, participating in a target-date fund is a wise option. Fidelity offers the Freedom Funds plan and Vanguard offers the 2030 Fund for a person retiring in 21 years. These plans are tailored to each individual’s retirement date and provide one-stop investing. As you grow closer to retirement, the mix of stocks and bonds adjusts automatically. Unfortunately, some misuse these funds by investing in multiple target-date plans with different dates. While it probably will not ruin you, it will hurt your savings strategy.
6. Watch the fees
Running into investment, administrative, and service fees and expenses can strain your retirement fund, so make sure to read the fine print before deciding on any 401(k) scheme. A low-cost index fund will charge the cheapest fees, which can go below 0.1% of your assets. A 1-2% difference in fees can mean a 30% reduction in your savings. It is best to find expense ratios less than 1%, but the most important factor in choosing stocks or bonds is comparing fees within that asset class because there is a large variation. A more detailed explanation of 401(k) expense ratios can be found on the U.S. Department of Labor’s website: http://www.dol.gov/ebsa/publications/401k_employee.html.
As long as you are able to direct your investments intelligently, you will be ahead of the curve come retirement.
Source: 401(k) Mistakes to Avoid – CBS Money Watch