Post on 28-May-2018
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© 2012 Morningstar, Inc. All rights reserved.
How to Make the Most of Your 401(k)
(or 403(b)/457)
× Christine Benz, Director of Personal Finance
× Adam Zoll, Assistant Site Editor
Money Smart Week, April 7
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Why a 401(k) (or a 403(b)/457)?
× Payroll deduction is an easy and convenient way to save for
retirement
× Your employer may provide matching funds that help your retirement
savings grow faster
× Earnings in the account grow tax-free or tax-deferred
× You get a tax break when you contribute to the plan (with a
Traditional account) or when you take money out (with a Roth
account) once you reach age 59½
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4 Key Questions to Ask
× How Good Is My Plan?
× Are My Savings on Track?
× How Should I Allocate My 401(k), 403(b), or 457 assets?
× What Do I Do With the Assets When I Leave My Job?
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Question 1: How Good Is My Plan?
Things to consider:
× Fund lineup
× Fund expenses
× Plan expenses
× Company match
× Roth 401(k) option
× Availability of additional help
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Fund lineup
× At a minimum it should include:
× U.S. large-cap stock fund
× U.S. small-cap stock fund
× Foreign-stock fund
× Bond fund
× Index funds: often your cheapest option
× Target-date funds: good for set-it-and-forget-it investors
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Fund expenses
× Charged by the company that runs the fund
× Appear on your plan disclosure statement and expressed as a % of
assets and as a dollar amount per $1,000 invested
× Actively managed (non-index) funds should charge no more than 1%;
index funds no more than 0.25%
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Plan expenses
× Charged by the plan provider to cover record-keeping, customer
service, administrative costs, etc.
× These may be spelled out on your plan documentation, or you may
need to ask the plan administrator
× Find out about fees charged for services such as using the plan's
brokerage window or taking out a loan
× Smaller-company plans tend to cost more for participants than larger-
company plans
× Median 401(k) fees per participant (including fund and plan expenses;
Source: ICI, 2011):
× Plans with <100 participants: 1.29%
× Plans with >10,000 participants: 0.43%
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Company match
× Money the company contributes to the plan on your behalf
× Typical setup: Employer contributes 50 cents for each dollar you put
in, up to 6% of pay
× Find out the vesting schedule—when the matching money becomes
yours
× Even in a poor plan, it often pays to contribute at least enough to get
the match
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Roth 401(k) option
× Allows participants to invest post-tax money today in order to enjoy
tax-free withdrawals in retirement
× Best used by those who expect their income tax rates to be higher in
retirement than they are today
× May be combined with a Traditional 401(k) for tax diversification
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Additional plan features
× Find out if the plan offers free investment advice
× Ask about plan rules for hardship withdrawals—to cover medical or
college costs, or to purchase a home, for example
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If your plan is bad
× Talk to the company benefits department about where it falls short—
they may not be aware of the problems
× Consider saving enough for the company match, then maxing out an
IRA, then adding to the plan
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Question 2: Are My Savings on Track?
Things to consider:
× The role your 401(k) plays in your retirement plan
× How much you will need in retirement
× Road-testing your savings plan
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The role your 401(k) plays in your retirement plan
Other retirement-savings vehicles may include:
× IRA
× Social Security
× Your home (downsizing, reverse mortgage, etc.)
× Other savings
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How much you'll need in retirement
× Lots of moving parts: number of years until you retire, how much
you've saved so far, your savings rate now and in the future, whether
you will work in retirement, whether you have a spouse who also is
saving, and when you will take Social Security
× Common (but imperfect) rule of thumb: save 15% of pay, including
the company match and any IRA contributions
× Better still: Use online retirement calculators to see where you stand;
the more detailed, the better; try at least three different ones
× Consider talking to a fee-only financial advisor if needed
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Road-testing your savings plan
× As you get closer to retirement, use the 4% rule to see where you
stand
× Example: You've saved $500,000. Could you live on 4% of
that amount ($20,000) plus Social Security your first year?
× If you don't have enough saved, ramp up saving and/or consider
working longer
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Question 3: How Should I Allocate My 401(k), 403(b), or 457
Assets?
× Three key ways to allocate your 401(k) or other company retirement
plan
× Method 1: Buy a target-date fund and call it a day
× Method 2: Take advantage of “advice engine” provided by
your plan
× Method 3: Allocate your own assets
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Method 1: Buy a target-date fund and call it a day
× How it works:
× Target-date funds are designed to be “set it and forget it”
× Pick the fund that matches your anticipated retirement date,
and the target-date fund takes it from the there: sets and
updates stock/bond mix and selects underlying investments
× Morningstar’s favorite target-date series: T. Rowe Price,
Vanguard
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Method 1: Buy a target-date fund and call it a day
Pros
×You don’t need deep investing knowledge
×Enables you to take advantage of professional asset-allocation advice
×Limited upkeep requirements; may help you combat bad behavior
Cons
×Eggs in one basket: Most target-date funds feature funds from a
single firm, and few firms do everything well
×Target-date funds aren’t universally good; some are costly or draw
from subpar lineups
×Preset stock/bond mix may or may not suit your situation
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Method 2: Take advantage of ‘advice engine’ offered by your
plan
× How it works:
× You answer a series of questions about your financial
situation and other assets
× Advice engine suggests a recommended allocation using
funds available in your plan
× Some plans even take the next step and implement those
recommendations for you
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Method 2: Take advantage of ‘advice engine’ offered by your
plan
Pros
×You don’t need deep investing knowledge
×Usually free of charge
×Enables you to take advantage of professional asset-allocation advice
×Limited upkeep requirements; may help you combat bad behavior
Cons
×Not available at many employers
×Recommended stock/bond mix may or may not suit your situation
×Recommendations may not be 100% objective
×Portfolio may suffer from “de-worsification”—too many options
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Method 3: Allocate your own assets
× How it works:
× You determine the stock/bond/cash mix that best suits your
situation and preferences
× You research and choose individual investments
× You handle ongoing maintenance
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Method 3: Allocate your own assets
Pros
× Allows you to customize your choices and make updates when you
see fit
× Allows you to produce a portfolio that conforms to your philosophy
(e.g., all index funds)
Cons
× You may not have the time or knowledge to build and maintain the
portfolio
× Free rein/limited guardrails can lead to behavioral traps like
performance-chasing, excessive loss aversion
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How to allocate your own assets
Step 1: Arrive at a suitable stock/bond mix
Factor in your age
×Under 40, or even 50? Most of your portfolio belongs in stocks
×Over 50? Start taking risk off the table
Good sources of asset-allocation guidance include:
×Target-date funds (Vanguard, T. Rowe Price’s series are M* favorites)
×Morningstar Lifetime Allocation Indexes:
http://corporate.morningstar.com/us/documents/Indexes/AssetAllocatio
nsSummary.pdf
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Sample asset allocation for someone just starting out
× Investment mix of retirement assets for accumulators should skew
heavily (or entirely) toward stocks, be diversified globally
U.S. Stocks: 54%
Non-U.S. Stocks: 35%
U.S. Bonds: 6%
Non-U.S. Bonds: 1%
Treasury Inflation-Protected Securities:0%Commodities: 4%
Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2055
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Sample asset allocation for 40-somethings
× For people in their 30s and 40s, equity allocations remain high, but
bonds grow a bit; portfolio begins to be slightly less global
U.S. Stocks: 57%
Non-U.S. Stocks: 30%
U.S. Bonds: 7%
Non-U.S. Bonds: 1%
Treasury Inflation-Protected Securities:0%
Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2040
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Sample asset allocation for 50-somethings
× Bond stake increases at the expense of stocks; foreign weightings
continue to decline
× Inflation protection plays a greater role
U.S. Stocks: 47%
Non-U.S. Stocks: 19%
U.S. Bonds: 21%
Non-U.S. Bonds: 3%
Treasury Inflation-Protected Securities:3%
Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2025
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Risk continues to diminish at age 60 and beyond, but stocks
take up a big share of the portfolio
× Positions in safe securities—cash and bonds—drift up
× Inflation protection also increases to help protect purchasing power
Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2015
U.S. Stocks: 31%
Non-U.S. Stocks: 10%
U.S. Bonds: 34%
Non-U.S. Bonds: 5%
Treasury Inflation-Protected Securities:12%
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How to allocate your own assets
Off-the-shelf asset-allocation guidance is a start, but take into account:
×Human capital: volatility of work earnings
×Other assets, such as a pension
×Spouse’s asset-allocation choices
×How much you have saved (less = somewhat higher equity
weighting)
×Your risk capacity
×How long you expect to be retired (longer = higher equity weighting)
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Step 2: Populate your portfolio with high-quality core funds in
line with your asset-allocation preferences
Core Noncore
Large-company stocks and funds Company stock
Broad-market index funds Sector funds
Intermediate-term bond funds Small-company stocks/funds
Broad foreign-stock funds Emerging-markets funds
Balanced funds Region-specific funds
Target-date funds
TIP: 80%-100% of most portfolios should consist of core investments.
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How to identify great core funds
× Cheap out. Look for:
× U.S.-stock fund expense ratios less than 1.00%
× International-stock fund expense ratios less than 1.25%
× Bond-fund expense ratios less than 0.75%
× Simplify: Index funds can be a solid choice
× Evaluate quality of firm: Morningstar Stewardship Grades
× Look for long manager tenure: At least 5 years, preferably 25
× Consider past returns over a number of market environments (though
remember the limitations!)
× Read analyst reports for a qualitative overview
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Question 4: What Should I Do With the Assets When I Leave My
Job?
× Four key options
× Option 1: Take the money and run
× Option 2: Let it be
× Option 3: Roll it into an IRA
× Option 4: Roll it into a new employer’s plan (only an option if
you’re not retiring)
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Option 1: Take the money and run
Pros
×Access to a lump sum all at once—can use to pay off debt, etc.
Cons
×Ugly tax treatment: Money taxed as ordinary income plus incurs a
10% penalty if you’re under age 59½
×Your money will no longer benefit from tax-deferred compounding (or
tax-free compounding, if you’re in a Roth option)
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Option 2: Let it be
Pros
×Plan may be low-cost and top-flight
×Plan may feature options unavailable outside of 401(k)s, such as
stable-value funds
×If you’re over age 55 and have left your employer, can tap money
without a penalty (must be 59½ to tap an IRA)
×401(k) plans may have extra legal protections unavailable in an IRA
Cons
×Company may not allow it
×You may be paying an extra layer of expenses that you could avoid by
rolling over into an IRA
×Difficult to monitor many different accounts
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Option 3: Roll it into a new employer’s plan
Pros
×Can make sense if new plan is gold-plated: ultralow fees plus strong
investment lineup
×If using advice from provider, can get more holistic view of various
accounts
Cons
×Won’t be an option if you’re retiring
×May pay extra administrative costs that aren’t present in an IRA
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Option 4: Roll it into an IRA
Pros
×Can avoid extra layer of fees that may accompany 401(k) plans
×More choices: Can take advantage of “open architecture” and buy
almost anything
×Less oversight: Can roll multiple 401(k)s from multiple former
employers into a single IRA
Cons
×You may miss out on 401(k)-only choices, such as stable-value and
institutional funds
×May miss out on some legal protections available with 401(k) wrapper
×Lack of guardrails makes it easier to get into trouble
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5 Key Takeaways
× Pay attention to costs
× Always get the match
× Keep it simple
× Be holistic about your retirement plan
× Get help if you need it
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