How to Make the Most of Your 401K Plan

November 24, 2009 at 12:46 PM Leave a comment

So your company offers a 401(K) plan—you might be in it already, you might not be.  Even if you’re in, chances are good that the enrollment processed made your mind feel like mush, every fund description was in a foreign banking language, and you ended up just putting your money somewhere—maybe even in your company’s default fund (probably not a good idea!).  You’re not alone: 401(K)s confuse almost everybody.

But if you want to retire some day, your company’s 401(K) is probably your best best!  If you’re not in, you should get in. If you’re in but aren’t too sure where your money’s going, now’s the time to re-arrange your contributions.  Call it Fall Cleaning.

What’s a 401(K), anyway?  Why Use it?

A 401(K) is an investment account—just like one you’d open yourself to invest in stocks and bonds—with a shield on it to protect it from tax.  In an ordinary investing account, the money you put in taxed when you earn it ( income tax!) and any money you make in the account is taxed annually.  This is cutting right into your money-making. In a 401(K), just like in an IRA, your money is only taxed once, then it’s left to grow tax-free.  This tax break—letting you make money without having to pay for it—is the real key to money growth.

Don’t believe me?  Check out this 401(K) calculator from Bloomberg.

401(K)s have other benefits that IRA’s don’t.  IRA’s have strict limits to how much you can add.  Right now, a single person can add $5,000 ($6,000 over 50) to their IRA each year, while a married couple filing jointly can add $10,000 ($12,000 over 50).  401(K)s have limits, too, but they’re much higher: singles can contribute $16,500 ($22,000 over 50), while married couples filing jointly can contribute $33,000 ($44,000 over 50).

Some companies also offer a ‘company match’: for every dollar you add to your 401(K), up to a certain amount (up to your company), they’ll add a certain amount, too (up to a certain amount)!  If your company offer this, you need to get on board: that’s free money!

Here’s some more info about how 401Ks work:
How Stuff Works: How 401K Plans Work
IRS 401K Guide
Investopedia: 401K

Roth or Traditional 401K?

Offered a choice between a Traditional and a Roth 401(K)?  It’s a simple difference: a Traditional 401(K) taxes you when you take your money out, while a Roth 401(K) taxes you when you put your money in.

Money you put into a Roth 401(K) isn’t sheltered from income tax the year you earn it—it’s taxed as though you didn’t contribute at all—but, hey, you’d be getting taxed anyway if you didn’t contribute.  In a Traditional 401(K), of course, your contributions are free from normal income tax—but you’re going to make up for it by getting taxed on every penny you take out in retirement.  Once you pay your income tax on money put into a Roth 401(K), that’s it—that money is never getting taxed again, and neither is the money that money makes.  Oh, and neither account taxes your earnings annually—both let your money grow tax-free, so you earn way more than you would outside of a 401(K).

So which is better?  That’s the tricky bit: both accounts tax you only once, and neither have any other clear benefits over the other.  If you enroll in a Roth, you’re betting that getting taxed now isn’t as harmful to your money growth as getting taxed in requirement (and if you’re young, you’re probably right!).  A Traditional 401(K) assumes that getting taxed now is worse than getting taxed in retirement (and if you’re closer to retirement, you’re probably right!).  The decision’s yours, but take a look at this handy calculator for a more informed decision.  Just remember: We can’t know what taxes will be like in the future, so betting against a future tax rate is just that—betting.

Here’s more about Roth vs Traditional 401(k)s:
Roth 401k vs Regular 401k
Yahoo!Finance: Choosing Between Traditional and Roth 401(K)s

Max Your Company Match

This isn’t as common a benefit as it used to be, but even as we’re recovering from the recession, some companies still offer a ‘company’ match on their 401(K).

The terms are usually simple: for every dollar you contribute, your company will contribute a certain amount of money (mostly 25 cents, 50 cents, or another full dollar).  Let me stress this: this isn’t your own money coming from somewhere else—your paycheck, your benefits, or whatever—this is your company’s money going directly into your retirement account, and all you have to do is contribute to your 401(K)!  And nothing grows money better than more free money.

Of course, there’s a limit to your company’s generosity—a company match is only extended up to a certain percentage of your income.  So let’s say you’re contributing 10% of your salary to your 401(K) (nice work!), but your company match is only 50 cents per dollar you contribute up to 6%.  That means that for every 10 dollars you put in, your company adds 50 cents . . . your total match is $3.  It’s not as great as getting 50 cents for every dollar, but it’s still pretty sweet.

Unsure how much to contribute to your 401(K)?  Whatever you decide, if you get a company match, use all of that company match.  If your company matches your money up to 6%, 8%, or even 10% of your income, then that number is the minimum you should invest.  You’ll thank me later.

More on company matches:
Money Magazine’s More Money: 401k Matches are Back in Fashion
MyITForum: Max Out your 401K Company Match
eHow: How to Determine a Company 401k Match

Which Funds to Put Your Money In

Now here’s the really scary part of opening a 401(K): Deciding which funds to put your money in.  Here are three keys to keep in mind while choosing funds:

Diversify your funds as much as you can across large-cap stocks, mid-cap stocks, small-cap stocks, international stocks, bonds, and money market.  How much you contribute to each depends on where you are in your career. Here’s a great asset calculator to help you determine yours.

Some funds—target retirement funds—do a great job of diversifying your portfolio for you!  Target retirement funds are usually assigned a retirement year, and are designed to maximize returns over that time without putting your portfolio in too much danger.  If your company’s 401(K) offers a target retirement fund that’s quite close to your actual date of retirement, then putting most or all of your money there might be your best bet.  Except…

Watch out for fund fees! Every fund has fees attached to it, and these fees cut right into your ability to make money.

You’ll usually find these fees toward the bottom of a fund description, and they come in two forms: expense ratio and management fees.  The expense ratio is literally the cost of running the fund.  The management fees are just money in the fund manager’s pockets.  Adding the two together gives you the total fees of that fund.

Fund fees are expressed in percentages and tend to look small . . . who cares if your fund’s manager gets 0.80%?  Good for him!  But think about how those numbers add up: For every thousand you put into your fund (and you’ll be putting in multiple thousands per year ’til you retire), you get $8 skimmed off of it.  It’s not a tax, it’s not unavoidable, and it doens’t benefit you at all—it just cuts into your possible profits.  Avoid them!

The best fund fees for your money are in the 0.08% to 0.20% range—but there’s a good chance that you’ll find few of these funds in your options.  Try to put your money in them while keeping your portfolio diversified, and in sections where you can’t keep your funds that low (international stocks and bonds can get pricier), try to get as close as you can.  Some fees can range up to 1% to 3%–avoid them like the plague, even if they’re target retirment funds!  You can do a better job of handling your portfolio at a fraction of the price.

Finally, stick to index funds whenever possible.  Every 401(K) has a range of managed funds that promise to ‘look for up-and-coming winners.’  Screw that: nobody knows what the next stock winner or stock loser is going to be.  Index funds aren’t overseen by managers trying to predict the next hot stock: they’re simply set to follow a particular stock index, like the DOW, the DJIA, the S&P 500, etc.

Stick with them.  Most managers fail, year after year, to beat the overall market.  By putting your money into index funds, you are the market—your money’s always doing exactly what the market’s doing.  And without a pricey manager calling your stocks for you, your fund’s expenses are much lower—just check the expense fees at the bottom!

Can’t find index funds on offer?  They’re probably among the list you’re offered, but not labeled as index funds.  Head right to the expense fees and take a look—the lowest fees are usually in index funds.

What Others Are Saying:

CNNMoney: 401(K) Top things to Know
Motley Fool: Is Your 401(K) Foolish?
Rags2Riches: 401k and ESPP Notes
Fit and Wealthy Blog: 401K

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Sam Warren

I write about money matters that apply to my life—and hopefully yours!

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