Napoleon Bonaparte once famously said, “For everything, there must be a plan”.
Okay, so his plan didn’t work out so well. But when it comes to your retirement plan, yours still can.
Why? Because at the heart of a growing number of American’s retirement plans is the venerable 401(k) plan. For millions of American workers, 401(k) plans have become the cornerstone of retirement planning. According to the National Center for Employee Ownership, the number of 401(k) plan participants in 2006 was four million, holding an estimated $2.4 trillion in assets.
It's easy to understand why Americans embrace their 401(k)’s. With 401(k) plans, employees can sock away up to $15,5000 annually in tax-deferred investment accounts for employees under 50 years-of-age. Employees 50-and-older can contribute an additional $5,000 in “catch-up” money in 2007, according to 2007 Internal Revenue Service statutes. That means the money you contribute reduces your taxable income. Plus all the earnings grow tax-free until withdrawal. Better yet, more than 70% of all employers match investments with about 50 cents on your dollar. That's free money--well, almost.
What's not free is that these funds need to be managed. Your 401(k) is unlikely to produce optimum returns on autopilot. The good news is that you're in control, and the bad news is that you're in control. To succeed, you need a sound investment strategy, one that reflects your retirement needs, time horizon, and risk-tolerance level. Take the time to manage your funds wisely, and watch your nest egg grow.
Here are some commonly asked questions and answers about managing your 401(k) plan:
How much should I contribute?
As much as you can, as early as you can. If you can't contribute the maximum, some financial planners recommend annual contributions of about 10% of your annual salary. If you can’t manage that, try the “1% solution”. That simply means beginning with a percentage of pay you can live with and upping that rate by 1% annually. By all means, make every effort to take full advantage of your employer's matching contribution--any money you don't match is virtually thrown away.
Feeling broke? Don't worry, the effect on your take-home pay isn't as bad as you might think. Each dollar you contribute reduces an annual pay income of $50,000 by only $810, according to a recent study by Fidelity Investments (assumes a 6% of annual income to a 401(k) contribution in a 28% tax bracket).
Employees may contribute up to $15,5000, the IRS maximum in 2007.
What kinds of investment choices do 401(k) plans offer?
Most 401(k) plans offer up to a dozen investment choices. Among them: a mix of stock and bond funds, cash instruments, and company stock, and lately, exchange traded funds (ETF’s). Many plans also offer guaranteed investment contracts (GICs), which are issued by insurance companies and pay a fixed rate of interest.
What is asset allocation?
In its simplest sense, it's "not putting all your eggs in one basket." The key is to diversify your portfolio by dividing assets among stocks, bonds, and cash equivalents. The theory here is that, by spreading your plan assets around, you are minimizing your chance of losing money on a single poor performing investment.
By and large, 401(k) plan participants tend to favor tilting their plans toward stocks. According to a 2006 study by the Employee Benefit Research Institute (EBRI), at year-end 2005, equity securities— equity funds, the equity portion of balanced funds, and company stock—represented an average of two-thirds (68 percent) of 401(k) plan participants’ assets.
A good rule of thumb on 401(k) asset allocation strategies. Take advantage of educational opportunities your plan sponsor offers. Many provide simple to sophisticated model portfolios to help you through the process.
Also, review and update your asset allocation strategy annually or as circumstances dictate. A banner year in the stock market (sound familiar?) means you may need to rebalance your fund allocations to stay within your target range in a particular fund or category.
Can you give me an example?
A conservative investor, age 25 to 45, may have 50% of his or her assets in a stock index fund; 20% in long-term corporate bonds; 15% in short-term bonds; and 15% in growth company stock. In contrast, an aggressive investor may hold 65% of his or her assets in an aggressive growth stock fund; 10% in a stock index fund; 10% in long-term corporate bonds; and 15% in international stock.
If you have other retirement assets, like real estate, share certificates/certificates of deposit, and the like, don't forget to include them when determining your asset allocation. Check the Web for sites like SmartMoney's interactive work sheet to assist in your planning. Find it at: https://ecommerce.smartmoney.com/ecommerce/login?url=%2Fpowerallocator&host=selectjdl.smartmoney.com
How much risk should I assume?
A good rule of thumb: The longer your investment time horizon, the more risk you can accept. Younger investors get the green light from most financial planners to invest more aggressively in stocks that are riskier but pay higher returns. But as retirement approaches, you may want to reduce your stock allocation and shift money to bonds.
Some investors are born risk takers; others are not. Know which you are. Before making any decisions, be sure you have a complete understanding of the risk associated with the various funds in your 401(k) plan.
Understand that seemingly minor differences in rates of return translate into huge dollars over time. Let's say you contribute $5,600 a year to your plan with a modest employer match. Over 30 years, earning a return of 6% annually rather than 8% reduces your account from a potential $1.3 million to $936,000. That's $364,000 less for you to spend in retirement.
Remember, you're in this for the long haul. Don't get preoccupied with day-to-day or week-to-week market gyrations. It's all part of the game.
Are the funds in my 401(k) off-limits until I retire?
Not completely. But if you tap your funds early, you'll pay a 10% penalty on the amount you withdraw in addition to payment of regular income taxes.
Most companies allow you to borrow against your 401(k), and a growing number of employees are doing so. But be careful: If you lose your job, or get laid off, you must pay off the balance in 30 days or pay federal income tax on the amount you owe plus a 10% early withdrawal penalty.
You must begin to withdraw funds from your 401(k) at age 70 1/2.
What about fees?
Fees associated with running 401(k) plans typically are 1.5% or more. Small company plans may be higher. If you don't know what you're paying, ask the people in your human resource department.
The U.S. Department of Labor has a useful site on understanding the impact of 401(k) plan fees. Find it at: http://www.dol.gov/ebsa/publications/401k_employee.html.
What happens when I leave my job?
When you leave a company, your 401(k) might go with you. You have three options: If you have a minimum amount that your previous employer is willing to manage for you – say $3,500 -- $5,000, you can leave it in your company's plan. Or you can roll over the balance into a new employer's plan. If your employer does not have a plan, or you must wait before participating, you can deposit the money into a conduit IRA (individual retirement account).
Is it possible to use the Internet to manage my 401(k) plan?
In the Information Age? Sure. A growing number of plan providers are launching Internet sites that allow employees to manage their 401(k) plans via the World Wide Web. Employees can transfer funds, check account balances, and research fund performance with the click of a mouse, seven days a week, 24 hours a day.
The Internet is a good tool to evaluate fund performance. Check out www.morningstar.net for rankings and profiles of 7,000 funds.
A good user-friendly site for understanding the nuts and bolts of your 401(k) plan is the 401KHelpCenter. Find it at www.401khelpcenter.com.