Take charge of your 401(k)

January 11, 2002

A wartime bear market is a wake-up call to actively manage this retirement plan--and stick to long-range investment goals.

 

Cover Story

Take charge of your 401(k)

Jump to:Choose article section...Contribute the max—and the max has gone up Choose the right funds for your investing goals Review your plan regularly, and rebalance as needed Lobby your employer for a better plan Don't crack open your nest egg before retirement Don't like your 403(b)? There's a way out Think twice about keeping a 401(k) from an old job

A wartime bear market is a wake-up call to actively manage this retirement plan—and stick to long-range investment goals.

By Robert Lowes
Senior Editor

If you own a 401(k), you may have asked yourself questions like these over the past two years:

"How can I stop the bleeding?"

"Should I put all my money in bonds?"

"Do I know what I'm doing?"

You didn't ask such questions in 1999. No matter how you allocated your money in a 401(k) back then, the raging bull market almost always delivered robust returns. Investment mistakes were lost in the stampede. Many investors put their plans on cruise control and went to sleep.

Now the bear market that began growling in 2000—and intensified after the terrorist attacks last fall—has jolted these once-nonchalant investors into high anxiety. Now they dread opening their 401(k) quarterly statements and discovering that their accounts have shrunk again.

You can say one good thing about a bear market, though—it often wakes people up to basic investing principles. And the basics very much affect 401(k)s. You set goals, decide on your tolerance for risk, build and maintain a diversified portfolio, and hang on for a long ride. With patience and discipline, you'll amass a nice pile of money.

But 401(k)s—and look-alike 403(b) plans offered by nonprofit institutions—require additional finessing because of the laws that govern them. With just a little homework, you can manage your 401(k) through good markets and bad to a comfortable retirement. Here's how.

Contribute the max—and the max has gone up

There are three good reasons for pouring as many dollars as you can into a 401(k).

One, it's better to save too much than too little for retirement, and doctors have been tempted recently to slack off.*

Two, you want to minimize what you owe Uncle Sam. Income tax on your pre-tax 401(k) contributions and earnings is deferred until you start withdrawing the money when you've retired and you're presumably in a lower tax bracket.

And three, if your employer matches your contribution, why pass up free money? Ante up at least enough to get the maximum your employer will contribute. The most common match is 50 cents on the dollar up to 6 percent of income.

Regardless of the employer's maximum, federal law limits your pre-tax contribution to $11,000. Thanks to President Bush's 2001 tax overhaul, though, this amount will rise $1,000 a year between 2003 and 2006, to $15,000. Beyond 2006, increases will be keyed to inflation in $500 increments.

Bush's tax package also includes a "catch-up" provision that allows people 50 and older to kick in an extra $1,000 in 2002. This amount will stairstep $1,000 each year until it plateaus at $5,000 in 2006. A 50-year-old could contribute a total of $20,000 that year.

Choose the right funds for your investing goals

To build a solid 401(k) portfolio from a menu of fund choices, you've got to understand the fundamentals of investing. You can explore this subject more deeply at the Medical Economics Web site (www.memag.com), where you can read "What it takes to be a successful investor" under "Your Money 101" in the Library section. Or, immerse yourself in respected financial Web sites such as www.morningstar.com , or sites that specialize in 401(k)s, like www.401khelpcenter.com .

No matter where you get your education, you'll learn that anyone who's more than 15 years away from retirement should funnel most of his money into a spectrum of stock mutual funds: domestic and international, growth-oriented and income-oriented, large company (called a large cap, as in capitalization), medium company, and small company. Your financial education will include how to allocate your funds among the various types of investments you select (what percentage of your money to keep in each type).

Most 401(k) providers try to dumb down portfolio building. They assume participants are investment rookies and steer them to safe bets. A plan will usually include at least one middle-of-the-road choice, such as an index fund or a growth-and-income fund. You could put all your money there and sleep easily at night. Plan providers may offer prepackaged "lifestyle" portfolios based on whether you're an aggressive, moderate, or conservative investor (you take a test to find out).

Some recommendations from a 401(k) provider, though, should be taken with a grain of salt. For example, the fund administrator may suggest that a 40-year-old allocate 10 percent of his money to a money-market or other cash fund. Overly conservative, warns Mary McGrath, a financial planner and CPA with Cozad Asset Management in Champaign, IL. "Given their modest rate of return," she says, "cash funds should never be used as a long-term investment."

Fund choices should exploit the tax-deferral feature of your 401(k), adds St. Louis financial planner Richard Feldmann. "You may like a particular municipal bond fund, but it's tax-exempt already. Why waste tax deferral on an investment that isn't taxed?" asks Feldmann. "What works best tax-wise in a 401(k) are investments that you intend to trade more frequently and that would ordinarily generate capital gains tax. The 401(k) lets you sidestep the tax."

Another factor in choosing the right funds for your plan is the need to coordinate your investments. You probably have other investments outside of your retirement plans, and if you're married, your spouse may own some, too. So when you think about portfolio diversity, don't focus on your 401(k) alone.

Limited investment choices in your 401(k) will force you to look at the bigger portfolio picture. It's not uncommon for a plan to omit a particular fund category, such as a small-cap growth fund. If you want some of your money there and your 401(k) doesn't allow that, find your small-cap growth fix elsewhere—perhaps in your spouse's 401(k). That frees you to use your 401(k) funds to achieve other allocation goals.

The logic holds in reverse as well. If you own a fair amount of real estate outside your plan, for instance, don't include stock in real estate investment trusts in your 401(k), or you could be overloaded in real estate and overly vulnerable to a slump in that sector.

Your spouse's investment style may influence your own 401(k) choices, too. Cambridge, MD, internist Paul Reinbold says that his extremely cautious wife keeps all her 401(k) money in money-market funds. "Since she is so conservative, I can afford to be more aggressive with my 401(k)," says Reinbold. He owns an international fund and a growth fund.

Review your plan regularly, and rebalance as needed

Give your 401(k) a yearly checkup. Do the various funds reflect your original allocation percentages? If they don't, rebalance the portfolio.

"In any given year, some funds will outperform others," explains Richard Feldmann. "Maybe your international fund, which you want to be 10 percent of the portfolio, has done well and grown to 15 percent of the total. Meanwhile, your large-cap growth fund, which was supposed to be 40 percent, has shrunk to 35 percent.

"Rebalancing means that you shift enough money out of international and into large-cap growth so your percentages are back on target. This amounts to selling high and buying low."

A 401(k) that isn't reviewed and rebalanced can grow dangerously lopsided. Tech-oriented growth funds that flourished in the late 1990s—and came to dominate many portfolios—have taken the biggest beating in the current bear market. "If someone with a lot of tech in his plan had been rebalancing all along, he wouldn't have lost as much," says Feldmann.

There are still other reasons to monitor and calibrate your 401(k). Your employer may have introduced new funds to the selection mix, and one of them might better diversify your portfolio. Perhaps your nonplan investments have changed, creating a need to rebalance. Maybe you're nearing retirement, and want to shift from riskier to more conservative funds.

Mary McGrath wishes more of her doctor-clients would review their 401(k)s more regularly. Too many of them, she says, turn the adage "buy and hold" into "buy and doze."

"They select their funds, decide on the allocation percentages, and never change anything for 10 years," says McGrath.

In contrast to the dozers, however, there are doctors who pay too much attention to their 401(k)s. They're market timers, in essence people who chase yesterday's best performers and pay no heed to diversification. Nowadays, they can go at it full throttle, since many plans enable them to juggle allocations daily on the Internet.

The most obvious—though understandable—example of market timing was the broad shift of 401(k) money from stock funds to bond and cash funds after Sept. 11. With few exceptions, financial advisers like Richard Feldmann are telling 401(k) owners to have faith in Wall Street—it will rebound.

"The market has recovered from every historical shock this century—Pearl Harbor, the Kennedy assassination, the crash of 1987, the gulf war," says Feldmann. "If you get out of stocks now, you'll miss out on the next recovery."

Lobby your employer for a better plan

No matter how well you play the 401(k) game, inherent weaknesses in the plan may limit its growth. So ask your employer for the 401(k) you want. The big bosses may not comply, but you won't know that until you speak up.

One out of 10 plans, for example, offers six funds or fewer, according to the Profit Sharing/401k Council of America. Fewer choices make a plan more affordable for the employer, but restrict portfolio diversity. If that describes your situation, remind your company that 62 percent of plans offer 10 choices or more.

If you're a sophisticated investor seeking even more choice, ask for the option of a self-directed brokerage account. This will put thousands of mutual funds as well as individual stocks and bonds within reach.

A true investment hound will want the ability to buy mutual funds at depressed prices when the opportunity strikes. That's possible with plan-sponsored Web sites that allow investors to tweak their accounts on a daily basis. In 2000, 86 percent of plans gave investors access to their 401(k)s through the Internet or a company intranet.

One more item for your wish list should be a safe-harbor provision. This feature skirts the troublesome rule that ties 401(k) contributions of highly paid employees (like doctors) to those of employees whose pay is far lower (receptionists and clerks). Ordinarily, if employees on the low end don't kick in a minimum amount, the high-enders are prevented from contributing the legal maximum. Doctors discover that they're in this predicament when part of their 401(k) contribution from a previous year comes back to them as a taxable refund. Under the safe-harbor provision, as long as an employer contributes 3 percent of compensation for each employee or makes certain dollar matches, more highly paid employees can max out their share.

Don't crack open your nest egg before retirement

Borrowing from your 401(k) is usually a bad move, says Morningstar analyst Peter Di Teresa. "You're missing out on the full benefit of tax-deferred compounding," he explains. "Plus, if you don't pay back your loan on schedule, the loan is considered a premature distribution, and penalized 10 percent by the IRS."

Premature distribution means you've taken money out of the 401(k) before age 59 1/2. The 10 percent penalty even applies to hardship withdrawals. Most plans allow them, but the hardship must be so severe that you have no other means to handle it (such as borrowing from relatives or a bank). In addition to the penalty, you'll owe income taxes.

Early withdrawal is penalty-free under a few circumstances, but heaven forbid that two of them happen to you: Death or total disability. Less harrowing exceptions involve medical debt, divorce, and early retirement.

*See "Financial Survey: Retirement funding falls again," July 23, 2001.

Don't like your 403(b)? There's a way out

If you have a 403(b) plan, you may wish you had a 401(k) instead.

Both retirement vehicles have the same basic chassis. You select investments from a menu, fill them up with pre-tax dollars from your paycheck, and several decades later you have a nest egg.

However, investments available in 403(b)s—created for employees of nonprofit organizations such as hospitals—frequently aren't as attractive as those in 401(k)s. Many of the fund choices are annuities, which tend to yield a smaller return than the mutual funds so plentiful in 401(k)s, according to Morningstar analyst Peter Di Teresa. And annuities waste the tax-deferral status of a 403(b) because they're tax-deferred themselves.

A 403(b) needn't be an albatross around your neck, though. Ask your employer to convert it to a 403(b)(7) plan that a mutual-fund company like Janus or Fidelity administers. Now you can invest in mutual funds to your heart's content.

However, annuities typically charge a surrender fee of up to 7 percent if you retrieve your money before a certain time—usually, six to 10 years. So you'll need to serve your sentence in the annuity prison before escaping to the 403(b)(7).

Think twice about keeping a 401(k) from an old job

If you're like most people, you'll be changing jobs—and perhaps 401(k)s—at least once in your lifetime. So what should you do with the old plan?

Unless you're 55 or older, cashing out translates into a costly premature distribution. But you can avoid the 10 percent penalty and taxes if you move the assets of the old 401(k) into a rollover IRA, also known as a conduit IRA. Make sure you request a pain-free "trustee to trustee" transfer.

In contrast, if your employer cuts you a check that you intend to deposit in an IRA, he's obliged to withhold 20 percent for taxes. You can get it back on your next tax return, but in the meantime, you must make up the amount withheld—out of your own pocket—and deposit that in the IRA, too. Otherwise, the 20 percent withheld qualifies as a premature distribution. And if you don't deposit your 401(k) money into the IRA within 60 days, the entire amount is treated as a premature distribution.

If your new employer offers a 401(k), you can usually roll the old 401(k) into it. That option has one edge over an IRA rollover—a 401(k) shields assets from creditors, such as a victorious malpractice plaintiff. In some states, IRAs don't enjoy much protection.

Not sure about what to do? Park the old 401(k) money temporarily in a rollover IRA; you can stick it into your new plan later on if you like. But be sure not to fatten this rollover IRA with extra money; if you do, moving it to the new 401(k) won't be allowed.

What if the old 401(k) offers better investments than the new one? Most of the time, you can keep the old plan. But there's a disadvantage in having multiple 401(k)s—it's harder to stay on top of them.

"If you leave an asset with a former employer, you tend to abandon it mentally," says St. Louis financial planner Richard Feldmann. "I know of people who have quit jobs and abandoned 401(k)s worth $20,000."

 

Robert Lowes. Take charge of your 401(k). Medical Economics 2002;1:80.