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Twelve Tips for a Better 401K!

David Dietze discusses 12 tips for a better 401K.

Many employees a generation ago could look forward to a predictable pension at retirement. Employers were responsible for investing the monies set aside for these “defined benefit plans;” employees could focus on more pleasurable tasks.

Today, most employers have ditched pensions in favor of “defined contribution plans”  a/k/a 401Ks or, in the case of public/nonprofit sector employees, 403Bs. 

That makes us responsible for instructing our employers to deduct sums from our paychecks for our retirement, and largely puts the headache of how to invest those monies into our laps.  That responsibility carries it with peril, if we mismanage those investments, or opportunity, if handled wisely. 

While each 401K plan has its own set of investment choices, review of countless plans reveals recurring opportunities andpitfalls.  While there’s no substitute
for a careful review of the details of your plan, here are twelve pieces of advice likely to be helpful:

1.   Fill it Up ASAP

Needless to say, you can’t profit from your 401K unless you contribute to it. Many companies match contributions. If so, that’s an immediate 100% return on the amount you contribute!  You’re further incented since it may cost you as little as 60 cents of current cash flow for each dollar invested because contributions are typically tax deductible.

What’s more, all earnings are tax sheltered, so it behooves you to accelerate contributions.  Indeed, if your employer will let you, have your entire paycheck contributed in the first few months of each year until you hit the maximum amount the tax law allows you to sock away – generally in the 20% of salary area.  In 2012, the dollar cap is $17,000 for most employees and $22,500 for those aged 50 and older.

Actually, it’s not the nuances of the tax law that make the 401K so valuable. The more important aspect is that it serves as a virtual piggy bank.  Whatever you can get into the 401K is unlikely to come out for that whimsical purchase, and is also shielded from creditors.  The 401K is a great tool to enhance financial discipline.

2.   Roll It Out and Consolidate

Many 401Ks are owned by ex-employees, and were “left behind” when the employee cleaned out his desk to leave the job.  If that’s you, transfer it to an IRA without delay.  It’s typically costless and tax free.

In an IRA you’re not limited to a 401K’s restricted list of investment options. Even better, you’re not limited to funds, so you can sidestep the fees, the opaqueness, and the duplication that fund investing can entail.  With the right IRA broker, nearly every investment imaginable is available to you.

By consolidating this rollout with any other IRAs you may have you can reduce account proliferation.  That can help focus plus potentially reduce costs further, as you’ll have a bigger account to work with.  It also reduces the risk the account is forgotten, either by you or your heirs after your death.

3.   Integrate it With Your Other Holdings

Don’t invest your 401K in a vacuum, as if that’s the only account you own. That’s the problem with settling for many default options, based only on your age.  For example, you may have plenty of stocks elsewhere, and need to focus on fixed income.  A healthcare oriented mutual fund may not make sense if you’re set to inherit a boatload of Merck stock.  Your financial profile may be stronger or weaker than is typical for your age, so accepting a one size fits all investment program in your 401K, even if customized for your age, may be the wrong approach.

The correct approach is to create a spreadsheet of your assets.  Then, develop a game plan for the entire nest egg. Only then can you invest your 401K so it plays the right supporting role.

4.   Reduce the Diversification

The usual mantra is diversify, diversify when it comes to investing.  Not so when it comes to mutual funds.  That’s because each mutual fund typically contains hundreds of stocks. It’s typically managed to be a stand-alone portfolio; single stock risk is virtually diversified away.

So, adding another stock mutual fund to your 401K typically results in duplicated positions. Fund A may own Merck and decide to sell while Fund B buys.  The left hand doesn’t know what the right hand is doing. You end up paying for transactions that are not sharpening focus but merely canceling each other out.

The problem can even occur with a domestic fund and an overseas fund, because so much of investment return is driven by the sectors involved, not the location of the companies. Thus, if domestic Fund A decides to buy Exxon to take advantage of rising oil prices, international Fund B may be selling BP in anticipation of falling oil prices.  At the end of the day, your portfolio’s focus is dulled but expenses are higher.

So, make sure each fund in your 401K is truly necessary.  Less is more when it comes to your 401K funds.

5.   Prefer Cheaper Funds

Examine carefully the operating costs of your 401K fund choices. Gravitate to ones sporting lower costs. As the fund researcher Morningstar’s study found:  “In every single time period and data point tested, low-cost funds beat high-cost funds."  Or, as fund company Vanguard states:  "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision.”

In many cases index funds are less expensive and are good 401K picks.

6.   Avoid Strategies You Don’t Understand

It is common for 401K sponsors to offer many exotic and or hedge fund strategies among your 401K fund choices.  Avoid them.

They are often touted as a way to reduce volatility yet provide returns superior to fixed income.  Yet, you may already have that if you have a well-diversified 401K portfolio.

Novel strategies by definition don’t have long track records, so predictions are harder.  Novel strategies are premium choices; fees will be higher, and many less apparent ones, like borrowing costs and trading commissions, greater.

The names of funds of this ilk often include the phrases “hedged,” “long-short,” “futures,” “tactical,” etc.  The promise is always less risk, more return.  Bet against that being the reality.

Bottom line, if you can’t explain the strategy to your spouse, steer clear.

7.   Asset Allocate and Rebalance

Your 401K should include a fixed income selection and an equity fund selection.  A case can be made for an allocation to overseas as well as small cap securities.  The theory is you reduce your risk if you diversify widely, and your portfolio experiences less volatility overall if you include some asset classes that typically zig when others zag.

Whatever is the bottom line allocation, commit the percentage allocations to writing, and rebalance whenever there’s a material skew from the initial allocation.  This will happen as some funds’ values change relative to the others.

Rebalancing forces you to sell some of the outperformers and add to the laggards.  That’s a sound strategy to reduce risk and enhance returns but it’s tough to execute unless you develop a written asset allocation plan and adhere to it.  Some 401K plans allow you to sign up for automated rebalancing, and we think that makes sense.

8.   Don’t Market Time and Avoid Trading

We all occasionally pick up the newspaper, read a horrific article, and instinctively want to take cover with our investments.  Don’t.  Here’s why. First, if it’s in the newspaper the news is already widely disseminated.   The prices of your investments are bound to reflect the implications.

Any trade of your investments assumes there’s another party willing to take what you want to unload.  Don’t assume they are suckers.

That is not to say that if there’s a change in your financial picture, either a negative one, say a health setback or a job loss, or a positive one, say an unplanned inheritance, that it’s not appropriate to rethink your investments with a view to rejiggering your risk/reward profile.

9.   Avoid the Big Wall Street Names

Many 401K plans include funds choices from different sponsors.  Some are Wall Street names which have been in the news amid allegations of not putting the client first.  Others are extremely heavy advertisers.  Funds sponsored by names in either of those categories are suspect:  They are more likely to be linked with novel strategies or charging high fees to pay for that advertising, etc.  Avoid.

Investor owned sponsoring organizations, a/k/a “mutuals” are less likely to commit those sins, and more likely to offer lower fees.  Vanguard is an excellent example, and their funds often make great 401K choices.

10.  Don’t Chase Performance

You can’t buy past performance.  You want to buy low and sell high.  Yet most 401K owners invest in the top recent performers.  Unfortunately, the research shows all strategies, portfolios, managers and asset classes have periods of underperformance.  By jumping in after the good times, and bailing after the bad, investors set themselves up for sub-par returns.

Choose intelligent asset classes and strategies without regard to recent performance. Indeed, consider funds with intelligently constructed portfolios after a period of sluggish performance.  Your 401K provider typically has carefully screened your fund choices, so jumping into a fund after a period of weak performance will often make more sense than the opposite.


11.  Avoid Cash

Most people on the planet hold cash because what little they have is needed for short term needs.  As a 401K owner, you’re one of the luckier ones who have some resources that can be invested for longer term goals.  Don’t invest in a way that suggests you have to devote the money to next month’s rent.

This is particularly true today, with yields on money market funds, a/k/a cash, nil.  Oh sure, you might get lucky and time the market and be able to use the cash to pile in after a market selloff.  But, that’s unlikely.  Stay invested.


12.  Consider Tax Inefficient Strategies Best Avoided in Taxable Accounts

Long term capital gains on stocks, as well as their dividends, enjoy a reduced tax burden if held in a taxable account, but no tax advantage if held in a tax sheltered account.  Nearly every other type of income producing security, save for municipal bonds, receives no tax advantage when held in a taxable account, but is completely sheltered from taxes in a 401K. 

Accordingly, if preferred stocks, CDs, high yield, corporate, foreign, Federal, or agency bonds, or convertible securities are part of your overall strategy, you’ll maximize the tax sheltering benefit of your 401K if held there. Any high turnover equity strategies would also be more strategically held in your 401K.  Finally, some commodity based funds are taxed less favorably than traditional equity funds, so may also be better held in 401Ks.



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kemosabe October 08, 2012 at 07:20 PM
Gunny you make em no sense. The government doesn't play with the pension money. It's actually invested unlike the Social Security fund's fake Algore lock box Where you have proof it was raided? Show me the checks that were cut.
kemosabe October 08, 2012 at 07:40 PM
Gunny how about STate give less state aid to West Orange and put into pensions instead? That would be about $5 million for town and another $6 million for schools. Which you want? Pensions or pay for services and staff? http://nj-westorange.civicplus.com/DocumentCenter/Home/View/215 West Orange spending is 70 million. Pensions cost 6.6 million. plus healthcare costs of 9.7 million so 16.3 million goes for benefits.
jerseyswamps October 08, 2012 at 07:52 PM
kemosabe, what was it you Indian folks used to call the President of the U.S.?
Gunny October 08, 2012 at 07:53 PM
Kemosabe, There's really a very simple solution that no body wants to address. People like yourself, just like to spew venom and anger over taxes and your own career choices. But to answer the question, it's quite simple. People pay a little more into the pension system. The percentage rate was raised last year and should be raised again in another 5. BUT, the state needs to stop raiding it whenever they feel the need. And second, employees need to contribute a little more for health benefits. Lastly, and this is a topic I've spoken about for years. MERGE. There's no reason for all of these municipalities to have their own little kingdoms. It's either merge or be lost.
Phil October 08, 2012 at 07:54 PM
bo bo, it was always an untouchable line-item in the budget until Whitman made it optionally. Kind of like the transportation trust fund that's supposed to run. Maybe if these items hadn't been made "optional" our state spending would have been curtailed all these years.
Gunny October 08, 2012 at 07:59 PM
Do your own research coach.
Phil October 08, 2012 at 08:01 PM
bo bo bagens, is that the 9% they're contractually obligated to put in with no say on where the money goes or how it's invested, just that it's managed by the party in charge's pick, or the additional money, without match, they can put into 403bs?
kemosabe October 08, 2012 at 08:02 PM
Gunny people like you like to lie. No one raided anything. That's a cheesy word people use to inflame debate. The state only has so much to doll out to schools and towns mostly failing urban cetners and cannot put it into pensions on top of the high tax burden we all face.. The pensions are criminial. They steal from taxpayers to pay benefits for a few...this kills middle class taxpayers! I don't want to pay income, sales, property taxes for you or anyone else's pension. I want to save for my own retirement and for my kids. NJ is spending $3 B in 2012 on pensions. That's money taxpayers could use to pay bills. Where are your priorities? Pensions for a few or tax relief for the many? Merging towns is a very good idea I will grant you that.
Phil October 08, 2012 at 08:04 PM
bo bo, because medicare and social security are paid for under they're own payroll tax which shouldn't be touched or changed. Instead it's the same thing happening with pensions, it's a slush fund opportunity for all federal politicians to take and spend how they please. If it isn't touched, it will last as each generation puts money into it.
I am Spartacus October 08, 2012 at 08:07 PM
The simple solution is to axe the defined benefit plan & go to a defined contribution plan. Workers can opt to either get the money invested in an annuity or self manage their investments if they feel comfortable w/ the responsibility.
Jrz Shore October 08, 2012 at 08:09 PM
Stop drinking the Cool Aid Bo Bo. While Whitman gave all NJ municipalities a "holiday" on pension payments for seven years and every governor over the past 16 years has not paid their required payments into the pension system, have you ever received a tax relief check or notice from your town or state? NO!
kemosabe October 08, 2012 at 08:10 PM
How typical....I have. Towns and school districts pay $2 BILLION a year towards pensions. State pays another $1.3 B this year. That's $3.3 B of money taxpayers pay for and get ZERO BENEFIT FROM!!!!! How does a pension improve roads or make children smarter? Taxpayers getting shafted
kemosabe October 08, 2012 at 08:11 PM
Employees will get pay raises if they no longer have to contribute to pensions too! I bet they like more cash in pocket for gas and groceries
Cardinal October 08, 2012 at 08:12 PM
Romney just rec'd 1 Million $$$$ from a Foreign Co, an Insurance Giant of Canada. Supreme Court made that legal !!!!!!!!!
kemosabe October 08, 2012 at 08:12 PM
Medicare spending is $800 B more a year than the taxes it collects. It is what makes deficits so high. Obama admitted during the debate this.
kemosabe October 08, 2012 at 08:15 PM
Obama just got $1 million from Al Qeda to thank him for not securing Libya
kemosabe October 08, 2012 at 08:25 PM
Jrzeshore - where would the extra loot have come from to fund the precious pensions of the few at the expense of the overburdened taxpayer?? Did Corzine not do it because he didn't want to or had to hand out the cash to his union pals like the NJEA. It's just simple arithmetic. All we need to know is where the pension money should come from.
Tax Playa October 08, 2012 at 08:33 PM
@ Gunny- Kemosabe is correct. Pensions should be eliminated. They are mathematically impossible to fund. Rhode Island is taking the first step to make at least new employees go on a 401-k and freezing benefits. Many states will follow. New Jersey has to do this or it will be insolvent in the near future. Or we will have to raise taxes beyond your imagination. The whole system is completely unsustainable. Read this report by PEW for information. http://www.pewtrusts.org/uploadedFiles/wwwpewtrustsorg/Reports/Retirement_security/Widening%20Gap%20Brief%20Update_webREV.pdf The problem is that our politicians are a bunch of wusses (who get pensions) and dont have the backbone to stand up to this theivery. Just think about this. New Jersey unemployment rate is about 10%, why do we have to give that person a pension and health benefits to take a job in the public sector. I think that person will take any job right now...
kemosabe October 08, 2012 at 08:35 PM
Pensions. More debt. More tax burden on our children. Add this to Obama's $16 Trillion growing to $25 trillion national debt. Our children are bankrupt before they even have a chance. http://www.nationalreview.com/corner/315197/states-real-debt-burden-4-trillion-veronique-de-rugy
IMHO October 08, 2012 at 08:42 PM
I didn't go to MIT but it seems that the pension math just doesn't work. I hear people on here complain that if only the pensions were funded properly the money would be there so please explain this to me. If a local employee who starts at around 30k but retires at 125k with a 75% pension (94k a year) How much would they need to put away to get that kind of guaranteed return for life? The answer is about 2,000,000. so how does this pension math work? even if 20% of income was going into pension it would fall way short.
Cardinal October 08, 2012 at 08:51 PM
A 1 Trillion dollar deficit is what Bush left Obama the 1st day Obama stepped into the office PLUS 2 unpaid for WARS & a Tax Cut for the Wealthy UNPAID FOR. Bush also left an Economy in Near Collapse not a Recession but very close to a Complete Economic Collapse where 20% unemployment was highly likely if not more. How soon we all forget!
tryintosurvive October 08, 2012 at 08:54 PM
It only works if someone else is paying, which for the public sector is the taxpayers. If the employee needs to fund it themselves it is impossible. Unfortunately, the gimmick is that the politicians promise to continue the pensions and gold plated benefits to get elected. All public sector employees and retirees vote as a block to keep the gravy train going. Even if they have to pay high taxes themselves (due to these pensions and benefits), they get most of the money back in their own benefits. Until there are enough people in the private sector who would not vote for the politians who sustain this continuous cycle, it will not end. Complaining that the pensions should have been "funded" is a joke. The politicians gave away unaffordable pensons and then we are shocked that there is not enough money for the state to put into them to fund them. Duh.
Monk October 08, 2012 at 09:00 PM
People should be more self-reliant. It fosters personal responsibility, personal industry, personal innovation and personal efficiency. The one with "skin in the game" is the one who will better budget and conserve resources. Pensions/allowances are for socialists and those who lack the capacity to care for themselves. There is so much misunderstanding and hypocrisy when it comes to wealth and resource management. The idea that government is the best custodian of wealth and resources is a pipe dream.
Tax Playa October 08, 2012 at 09:04 PM
AMEN!!!!!
kemosabe October 08, 2012 at 09:05 PM
When losing an argument like claiming PENSIONS for UNIONS are GOOD at the expense of the taxpayers, liberals revert to Blame BUSH strategy. Explain it to us Tonto how does one cut something that is then unpaid for? Maybe the govment shouldn't be spending more than it takes in. Why do they spend $800 B on Medicare more than they take in. Isn't spending more than you have UNPAID? Did Bush make that happen? 4 years of Obama in office and 4 $1 trillion plus deficiits. Now, I seem to recall he promised to cut that in half. Are you admitting he failied? Pensions are UNPAID for too by your definitions. What is your answer to paying for them? Raise taxes on the overburdened NJ Middle Class for a handful of government workers. Come on, we thought you cared about the middle class. How many NJ middle class are government employees?
kemosabe October 08, 2012 at 09:12 PM
http://newjersey.watchdog.org/2012/04/02/100k-club/ Taxpayers paying for $100k pensions. Is $100k in pension income considered Middle Class? How much do you have to save to get GUARANTEED $100k a year from the taxpayers?
Jack B Goode October 09, 2012 at 01:13 AM
"you didn't build that" Mr President , I 've been in business for 25 years, and I don't know what you're talking about"
Jack B Goode October 09, 2012 at 01:14 AM
http://www.google.com/url?sa=t&rct=j&q=obama%20deficit%20increase&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.cbsnews.com%2F8301-503544_162-57400369-503544%2Fnational-debt-has-increased-more-under-obama-than-under-bush%2F&ei=W3pzUODuJo2o0AHhtoEQ&usg=AFQjCNGpxtfM93w5O06bWr9BbNOZQIGD_w Obama has increased the national debt more in 4 years than Bush had in 8 Years Thats the fact Jack! national-debt-has-increased-more-under-obama-than-under-bush
Jo October 09, 2012 at 02:14 AM
He meant you didn't build the roads that you used to get to your company or used to move your goods to market, the roads your customers drove in on. the public waste and sewer system that made sure your business didn't smell like poop. You built that, with your enighbors, through taxes. I like that my town doesn't smell like poop, I like that a mountain stream doesn't rage through my foundation becaus of storm drains, I like that I have paved roads, I enjoy flushing the toilet in a state with 9 million butts and being able to trun on the faucet right after knowing the public water supply is one of the safest in the world. The police, fire, national guard that kept your proerty safe from fire and mirauding bands. My husband owns a small business. He didn't take a loan beyond a loan on his truck, borrow money from anyone, govt or parent, and he did build the base of that company himself, but he knows, as do I, that he wouldn't have gotten very far without help from police keeping job sites safe, DPWs plowing roads so that in the 15 years he's been in business pretty well as soon as the snow finally stopped, he could get out and get to customers all over northern NJ. That's what I heard in the "you didn't build that" speech. But I listened to it in it's entirety, not just right before that clip. It's very clearly explained later on and nothing similar to what was prtrayed. Not that that's anything new. Zealots on both sides do that all the time.
Gunny October 09, 2012 at 04:31 PM
I think someone needs to move out of his mother in laws house soon. Coach is that third floor getting to you yet?

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