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In this day and age, with pensions mostly a concept of the past, it’s up to you to save for your own retirement. So what type of investment should you choose? Investing in a 401(k) or IRA are both good options.

Many companies offer employer-sponsored 401(k) accounts for workers to save and invest for the future. As you’ll learn in this post, growing and protecting your 401(k) balance is vital to a secure and successful retirement.

So how can you get the most out of your 401(k) and what are some of the key things to remember? We’ll discuss important concepts behind the most effective ways to save. We’ll also look at strategic methods to rolling over your 401(k) into another retirement account. Check out the following tips to maximize your retirement savings

1. Don’t leave free money on the table

The first rule of opening a 401(k) account is to take advantage of your company’s match for “free” money. Many employers contribute a certain amount to your retirement savings plan based on the amount of your own annual contribution. Occasionally, employers opt to match employee contributions up to a certain dollar amount, regardless of your salary. If you’re not sure what your employer’s policy is on matching 401(k) funds, find out today.

What should your minimum contribution be? You’ll want to contribute no less than the minimum amount required to take full advantage of your employer’s match. Don’t leave free money on the table!

For example, let’s say your employer matches 50% of your contributions that equal up to 6% of your annual salary. If your salary is $60,000, the contributions equal to 6% of your salary, or $3,600, are eligible for matching. However, your employer only matches 50%, meaning the total matching benefit is capped at $1,800.

If your employer matches a certain dollar amount, you must contribute that amount to maximize benefits. This rule is true regardless of what percentage of your annual income it may represent.

TIP: After you have your 401(k) contributions set high enough to get your employer match, I would suggest funding an IRA.  An IRA will often offer you more investment options and better withdrawal flexibility, with the same tax benefits.  Move back to contributing to your 401(k) after fully funding your IRA.

2. Take care of the R&R work (risk tolerance and research)

Set realistic expectations

Let’s say you’ve made sure you’re contributing enough toward your 401(k) to receive matching funds from your employer. Now it’s time to focus on risk tolerance and investment research.

You wouldn’t expect the casual pick-up basketball player to go one-on-one with an NBA star. So you shouldn’t have the same hopes that your conservatively allocated 401(k) will perform as well as a more aggressive portfolio. In other words, you can’t expect to take a low risk and realize a high return.  

It’s unrealistic to hold an allocation that is, for example, 40 percent bonds and 60 percent stocks to the same standard of the S&P 500 or Dow index. It would be like comparing apples to oranges, as both of the latter entities are comprised of 100 percent stocks.  

With your 401(k), you’re taking a more conservative approach by adding 40 percent bonds in order to take the volatility out of the portfolio so it’s not so erratic.

Also, use relevant benchmarks when assessing the performance of your mutual funds and avoid taking a “what have you done for me lately” approach. Extend some grace for quality mutual funds if there are a couple of years of subpar performance before you do anything drastic.

Over a hundred years of history reveal average returns of quality stocks exceed those of just about every other investment vehicle out there. There’s no reason to expect returns every year like we saw in 2013, when the S&P 500 posted its largest annual jump in 16 years and the Dow its biggest gain in 18. Growth like that is not sustainable long-term, nor necessary for you to achieve your financial goals.

Decide how much to save

There are annual limits to what you can put in your 401(k) or other defined benefit plan. In 2016, if you are under 50 years old, you can contribute a maximum of $18,000. If you’re 50 or older, you can make an additional catch-up contribution of as much as $6,000, for a total of up to $24,000.

Given a 401(k) plans’ valuable tax breaks, it works in your favor to invest the maximum if you can. (after maxing out your IRA first)

Be aware that the contribution limits typically change annually to track inflation. Inflation will gradually reduce the value of a dollar. So these increased limits allow you to contribute more so you can maintain your purchasing power in retirement.

Reminder: If you can’t invest the maximum amount, try to contribute enough to qualify for your company’s maximum matching contribution, as outlined earlier.

Do your research

Don’t just blindly choose the funds for your 401(k). It’s important to first do some research in order to decide on the most appropriate allocation of investments for your situation. And, once you’ve chosen the funds, don’t just leave them year after year without any further analysis.

It’s important to periodically look at how your portfolio is performing and rebalance the funds when it makes sense. When reviewing your investment options, first focus on the composition of the mutual fund within your 401(k). Which individual stocks/bonds are currently held in the mutual fund, and how do you feel about those individual stocks/bonds moving forward? Other key metrics to consider are the fund manager’s tenure, the amount of turnover in the portfolio, and the risk of your portfolio.

Most people have the tendency to gravitate toward the past performance of the mutual funds as their deciding factor. But remember that past performance is not necessarily indicative of future performance. Just because a mutual fund is in favor this year or has done well in the past doesn’t mean it’s going to continue to do so. On the flip side, just because it’s done poorly in the past doesn’t mean it’s going to do poorly in the future.

Research these mutual funds with an eye toward the future. Which of them are positioned to do well in the current or longer-term economic environment?  

Understand what funds you own and why you own them. If you have a financial advisor, use him or her as a resource to help you assess whether your portfolio is still working for your current situation.

Finally, staying abreast of your 401(k) terrain is especially important in case your company changes the makeup of your plan. If your plan’s sponsor adds or deletes options, you need to be prepared to alter your 401(k).

BONUS TIP: Don’t tinker.

Even though your 401(k) account is protected from taxes, you should still avoid moving money around every time there’s a fluctuation in a stock.

Try not to be overly alarmed by economic news headlines. Instead, focus on ensuring you have an allocation that’s appropriate for your time horizon. Before you put any tips you’ve received into action, make sure you have a time horizon that matches it. Other people may be more risk-tolerant than you or have more time to recover from the volatility that comes with their particular strategy.

Avoid frequently making changes to your funds. Instead, do some research on how to rebalance your original 401(k) mix periodically as outlined in the previous point. Your portfolio’s risk/reward profile won’t be altered much, but it’s a way to capture some gains and buy mutual funds that may be “on-sale”.

3. Make the right 401(k) decisions when retiring or switching jobs

When you leave your job, whether it’s to embark on retirement or pursue another opportunity, don’t forget about your 401(k). You have a few choices of what to do with this investment account when you’re no longer under your company’s plan.

Don’t cash out all at once

Can you cash out your 401(k) and take the money? Technically, yes. But you should do everything you can to avoid it. Cashing out early will cost you a bundle in penalties and lost growth over the next few decades.

In the eyes of the IRS, cashing out your 401(k) before you are 59 ½ is considered an early withdrawal and is subject to a 10 percent penalty on top of regular income taxes. And, since the 401(k) is funded with pre-tax money, you also have to pay taxes on it when you cash out.

In most cases, your plan administrator will mail you a check for 70 percent of your 401(k) balance. That’s your balance minus 10 percent for the withdrawal penalty and 20 percent to cover federal income taxes (depending on your tax bracket, you may owe more or less when you file your return).

NOTE: Even if you’re over the age of 59 ½, and ready to retire, don’t just cash out.  There is no need to pay taxes all at once on money that you are going to access over time.  Instead, withdrawing what you need, as you need it will help you manage your tax burden.

Why rolling your balance into an IRA could be the best strategy

Your former employer may allow you to keep your funds in its retirement account after you leave, but this may not be the best option.  If you plan on changing jobs a few more times before retirement, keeping track of all of the accounts may become cumbersome.

Also, you will no longer be able to contribute to the old plan, and your investment options are more limited. Let’s take a look all the reasons why it’s probably a better idea to roll your balance into an IRA:

More investment options

An IRA offers much more potential to grow your money versus a 401(k). Options are fairly restricted within a 401(k), and an IRA gives you a much wider array of investment options. A typical 401(k) generally offers 10 to 30 investment options, while options within an IRA are virtually limitless.

Easier to use customized beneficiary designations

Most IRA plan documents provide default beneficiary options. For instance, if you name two individuals as your designated beneficiaries and one dies before you, the share that belongs to the deceased beneficiary automatically goes to the surviving beneficiary. An IRA also allows you to prepare a customized beneficiary designation, however. That way you can make specific preferences for what you would like to happen in that situation. For example, you could stipulate that his/her share goes to his/her children. Many 401(k) plans won’t accept customized beneficiary designations.

Access to 72(t)

Do you need to access your retirement money early? Usually, anyone who takes money out of an IRA or a retirement plan prior to age 59½ faces a 10% early withdrawal penalty on the distribution. With an IRA, however, you may be able to avoid the requisite penalty by taking distributions compliant with Internal Revenue Code Section 72(t).

Any money you take out of the plan will amount to taxable income. But you can position yourself to avoid that extra 10% tax hit by breaking that early IRA or retirement plan distribution down into a series of substantially equal periodic payments (SEPPs). These periodic withdrawals must occur at least once a year. They must also continue for at least 5 years or until you turn 59½ (whichever occurs later). See this previous post for more information on the logistics of a 72(t).

No automatic 20% withheld for taxes on every withdrawal like the 401(k)

When you cash out a 401(k), your employer will withhold 20% in federal income taxes and 2% to 8% in state income taxes. All money is considered earned income and could bump you into a higher tax bracket. Obviously larger withdrawals will result in more income tax and a higher tax bracket.

On the other hand, when you take a distribution from an IRA, you choose what amount to withhold for taxes.  This comes in handy when you know what your tax rate is going to be. It also keeps you from giving the government an “interest-free loan”. (aka a tax refund)

Bonus tip: Age 55 rule

We’ve established that rolling into an IRA is the best option. If you’re between the ages 55 and 59 ½, be certain you don’t need to take advantage of this penalty-free option before you roll all of the money.

With the Age 55 rule, penalties may not apply if you were terminated or resigned from your job at that age or older. Remember your 401(k) distribution will still be subject to federal income taxes.

The age 55 rule only applies to money in employer-sponsored retirement plans. So once you roll your money to an IRA, you can’t go back and use the age 55 rule.

The bottom line

I can’t guarantee your 401(k) savings plan will build all the retirement savings you’ll need. The value of such an account depends on many factors. The amount you save, how long you have before you retire, and how well the stock market performs over that time are all contributors. And sometimes it’s better to roll over your funds to another account such as an IRA in order to reap the best benefits.

One thing I can tell you is that “some savings” is always better than none. Hopefully this serves as a valuable guide to help you manage a profitable 401(k) account.


Author Ron L. Brown, CFP®

Ron is a CERTIFIED FINANCIAL PLANNER™ and President of R.L. Brown Wealth Management. He specializes in retirement, estate, and business planning for professionals and entrepreneurs. Ron assists his clients with creating a financial plan to ensure they are able to live their ideal lifestyle during retirement and leave a strong legacy for their family. Ron has been featured in The Wall Street Journal, US News, Yahoo Finance, Investopedia, and numerous other high profile financial publications.

More posts by Ron L. Brown, CFP®
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