A 401(k) plan, technically known as a Defined Contribution Plan, is an account where an employee may elect to have a portion of his/her salary directed for tax-deferred growth to be used in retirement. Created by the Revenue Act of 1978 as an addendum to ERISA (Employee Retirement Income Security Act of 1974), 401(k) plans have become the most common employee benefits program today.
But what’s popular is not necessarily what’s best.
Nobel Laureate professor of economics at MIT Robert C. Merton strongly criticized Corporate America for its abandonment of Defined Benefit Plans, called pensions for 401(k) plans, called Defined Contribution Plans. Where a pension guarantees an income for life, a 401(k) guarantees nothing. According to Merton, retirees need the income that cannot be outlived, not an unsecured promise of future accumulation. However, because 401(k) plans cost less and have less liability than pensions, corporate America made the shift. For the retiree, this translates to a swap from “we’ll take care of you for life” to “good luck in your retirement.”
A typical 401(k) permits the employee to contribute a portion of his/her salary into the plan, often (but not always) with matching contributions by the employer. Plan details vary from employer to employer. For the most part, 401(k) plans offer each employee a selection of investment choices, mostly mutual funds. The menu is at the discretion of the employer’s plan administrator. Plan participation is generally not required but is usually encouraged.
So, should employees participate in their company’s 401(k) plans? If the employer offers matching contributions, yes. When corporations structure their finances – that familiar pie chart we commonly see in company financial reports – the wedge of the pie that represents employee compensation includes the employer’s matching money. In other words, the employer’s match is part of the total employee compensation package, not in addition to it. But sometimes employees fail to contribute enough to get the full amount of matching money. Doing so is like asking their employer for a salary cut.
Unfortunately, 401(k) plan administrators rarely offer detailed advice beyond reciting the plan’s basic rules. This leaves employees under-informed and confused about what their plan is or how to effectively manage it.
The following guidelines are five ways to optimize your 401(k):
- Contribute the minimum amount possible to get the maximum match. If your employer matches, don’t leave money on the table. If they don’t match, don’t participate. Open and fund a Roth IRA account instead. Roth IRA’s grow tax-exempt, meaning they offer a great tax advantage when coming out in retirement. In contrast, 401(k) plans are tax-deferred meaning when you get the money it’s taxed as ordinary income. Moreover, like traditional IRAs, 401(k) plans are subject to the same schedule of Required Minimum Distributions. Not only are these distributions taxable as ordinary income, they can increase the tax load on your Social Security income, potentially resulting in “double taxation.”
- If you change jobs, roll your 401(k) into a traditional IRA. Don’t combine your previous 401(k) plans with your current. There’s no advantage to accepting the investment limitations offered within your current plan and there’s no matching on deposits from previous plans.
- Don’t continually rebalance your portfolio to meet changing market conditions. Let the mutual fund managers do that. Pick one or two basic funds and stick with them. History has shown that owning a bunch of different investments, especially the types commonly offered in 401(k) plans, do not significantly diversify the plan’s portfolio or increase long-term return over what occurs in one or two individual mutual funds.
- If possible, select funds that emphasize value and/or have a strong history of dividend payments. Both of these tend to increase return and reduce volatility.
- As Kenny Rogers sang “know when to hold ‘em, know when to fold ‘em.” When you reach retirement age (and retire) get out. Volatile stock markets and the schedule of Required Minimum Distributions don’t mix. Roll your 401(k) into a safe financial instrument such as a Fixed Index Annuity. These products offer respectable growth potential without exposing the account to market losses. In addition, annuities are the only financial product capable of generating guaranteed lifetime income. In other words, they’re true pensions and that’s what employee retirement plans are supposed to be in the first place.
