What to do when your 401(K) stinks
Q. I don’t think I have good investment choices in my 401(k) plan, but I’ve always saved the max. Does it make sense to save to an IRA instead and put the rest in some other kind of account where I can choose the investments?
A. There’s a lot to consider here.
If your employer offers a 401(k) and will match a percentage of your contributions, you should definitely take advantage of it, said Lisa McKnight, a certified financial planner with Lassus Wherley in New Providence.
She said most employers offer a matching contribution up to a certain percentage of your salary.
“For example, if your employer will match your 401(k) contributions up to 6 percent of your salary, you should always contribute at least 6 percent,” McKnight said. “That’s equivalent to a 100 percent return on investment.”
It would take years in an IRA to achieve that same 100 percent return, she said.
Over time, those contributions compound, leading to far more growth over the long term.
Next, consider taxes.
All the money you contribute to a 401(k) is pre-tax, she said. You are not taxed on that money during the year that you earn it. Rather, it is taxed when you withdraw it in retirement.
McKnight said in 2016, you can contribute up to $18,000 of pre-tax money to a 401(k) and if you are over 50, you can contribute an additional catch up contribution of $6,000.
She said saving to a 401(k) is easy and disciplined with automatic payroll deductions.
As you noted, in a company-provided 401(k), you are limited to choosing among the investment choices, typically mutual funds, that the plan offers.
“While your company may give you information about the funds, you’ll need to figure out which ones are best for you,” she said. “Since you’re bearing all the risk, it’s important that you choose wisely.”
McKnight said although you are limited to the funds within the plan, you do have control over which ones and the types of investments to use.
These should be based on your risk tolerance and investment horizon, she said.
She said your employer may offer tools to help you familiarize yourself with the risk/reward relationships. You will want to familiarize yourself with your choices.
“There should be a few target date funds, stock and bond funds and blended funds,” McKnight said. “Within each of these categories, there should be a number of funds to choose from, each with a different investment strategy and level of risk.”
If you do not feel comfortable choosing your own funds, then a target date fund may be the way to go.
“Target date funds will align with retirement dates such as Target 2020, Target 2025, etc.,” she said “These funds invest more conservatively as you near your retirement date.”
Target date funds are great options for people who want to invest in a fund that will automatically adjust the overall risk level as they near retirement, McKnight said.
Even if you end up investing in a target date fund, you may still want to invest in some other funds to further diversify your portfolio, she said.
There are funds that focus on a wide variety of different investments, all with differing levels of risk. You will likely have options that include funds that focus on international stocks, emerging markets or real estate.
If you are more of a do-it-yourselfer and want to choose your own funds, she recommends you look for index funds.
Most plans will have a handful of index funds.
“Index funds are style specific, low cost and track the performance of various indexes, such as the S&P 500, Russell 2000 or the EAFE,” McKnight said. “If your plan offers several low cost index fund choices, perhaps an S&P 500 or total stock market index fund, an international stock index fund and a bond index fund there is enough variety to serve as the core of a diversified portfolio — the division of your funds between stocks and bonds.”
If you are stuck with choosing from investment options consisting only of actively managed funds, she suggests you pick the ones in each asset class with the lowest expense ratio.
“Avoid all funds that hit you with a sales charge,” she said.
Additionally, you will want to avoid company stock, she said. Some companies encourage the purchase of company stock in 401(k) plans, and they may even make matching contributions in company stock.
McKnight said you should avoid purchasing company stock.
“You are already invested because you depend on your company for your paycheck. It would be a financial blow if your company went out of business and you lost your job,” she said. “Don’t compound that risk by adding company stock to your 401(k) plan.”
Now let’s look at IRAs.
McKnight said if you have a poor 401(k) plan and your employer does not make any matching contribution, you may want to consider participating in a self-directed plan such as an IRA or Roth IRA, or you can save to both.
She said you don’t have to choose between an IRA and a 401(k) as long as you are qualified and you heed contribution and income limits.
Be aware that there are restrictions with IRAs and Roth IRAs such as contribution and income limits.
“If you are able to participate in an employer-sponsored plan, then the deductibility of your IRA contributions will be subject to income limits,” McKnight said. If your income is too high, you cannot deduct contributions.
In 2016, your ability to deduct contributions to a traditional IRA begins to phase out if you earn more than $61,000 as a single tax filer or $98,000 if you’re part of a married couple filing jointly.
Roth IRAs do not provide a tax deduction for deposits, but allow you to withdraw money tax-free in retirement, McKnight said.
There are income eligibility limits starting at $116,000 for single taxpayers and $183,000 for married couples filing jointly. Those with earnings less than the income limits are eligible to deposit up to $5,500 into an IRA or Roth IRA in 2016. Those age 50 and older are able to deposit up to $6,500 in their account for the year.
Those above the income limits can still contribute up to the maximum to an IRA, but lose the ability to deduct the contribution, she said.
One drawback of an IRA is that it doesn’t offer the same level of creditor protection as a 401(k) plan, McKnight said.
Another downside of IRAs is that the onus is on you to vet investment options, she said.
“Most 401(k) plans offer a limited number of investment options, whereas with an IRA you are open to a much larger universe of investments,” she said. “It is your responsibility to vet and choose wisely.”
McKnight recommends you be aware of high fees and avoid higher-priced commissionable products. Your IRA may end up being more expensive than it needs to be.
Despite these restrictions, an IRA does offer more freedom of where you want your money to go, McKnight said.
Both are great tax-advantaged ways to save for retirement.
“Regularly contributing to either one is a great way to grow your investments for retirement. The more you contribute, the more your assets can compound over time,” she said. “You should strongly consider maxing out your contributions, especially if they are eligible for an employer match.”
McKnight suggests you consider the following:
1. If your employer offers a company match, then first fund your 401(k) up to the point where you get the maximum matching dollars.
2. Direct the next investing dollars to an IRA — a traditional IRA for upfront tax deductions or to a Roth IRA to get a tax break in retirement when you start making withdrawals.
3. After maxing out the IRA, return to your 401(k) plan to take advantage of the higher contribution limits and the higher current year income tax break.
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Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.
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