Getting the Most from Your 401(k) or 403(b)

The following is a guest post from Marotta Wealth Management.

For many workers, their retirement account is their largest asset. Having so much of your nest egg in one place means you should watch carefully how it is invested and monitor it regularly. Unfortunately, the average family spends more time planning their annual vacation.

The secret of making it financially used to be joining the right company, earning big bonuses and promotions and letting the firm provide for you in retirement through its defined benefit program. Your benefit in retirement was typically defined by your earnings over the course of your career. But as we all know, those days are over.

Today's average worker will have a dozen employers and work at each job for less than four years. Your career is now your responsibility, and so is your retirement plan.

Instead of a defined benefit program, most companies have defined contribution programs such as a 401(k) or a 403(b). In these you reap what you sow and the growth is subject to the weather of the markets. Nothing is defined.

A 401(k) and a 403(b) are virtually indistinguishable, named after the sections of the IRS tax code that define them. Businesses use a 401(k); schools and nonprofits use a 403(b). Most of the principles for evaluating and managing them are identical.

Some 403(b) plans and many 401(k) plans offer an employer match. Formulas vary, but the most common is to match the first 3% of your salary that you contribute at 100% and the next 2% of your salary at 50%. So if you put 5% of your salary into the company's plan, your employer will give you an additional 4% of your salary.

This is easily the fastest 80% return on your money. No one should pass up an employer match. If you are in the 25% tax bracket, each dollar you contribute will only cost you 75 cents. If you earn $50,000 and contribute $3,000, it will reduce your paycheck by only $2,250, and you may receive an employer match of $2,500. In other words, for $2,250 less in your paycheck, you can get $5,500 more in your retirement account.

Everyone should take advantage of matching plans and contribute at least the minimum amount required to receive a full match into the company plan. Unfortunately, many workers don't. In our example, between age 20 and age 72 at 6.5% return above inflation, the match would grow to more than a million dollars. Your first priority in saving should be to get the entire match.

The next step would be to fund your Roth account, make sure you are growing your taxable savings, and then return to contribute more to your company's retirement account. As we will see, there are good reasons not to contribute everything to your company plan.

The advantage of contributing to a Roth account is that your income (and therefore your tax rate) is probably increasing over the course of your working life. I've written extensively on the benefits of a Roth conversion this year, and that same reasoning makes funding a Roth IRA a good idea.

Many employers allow contributions to a 401(k) or 403(b) Roth. The more common pre-tax contributions are called a "traditional" 401(k) or 403(b) to distinguish them from Roth contributions. You should consider designating the portion you contribute toward a Roth. The portion your employer contributes, either matching or profit sharing, is always put into a traditional account.

If your income is significant, consider maximizing your contribution. The limit for 2010 is $16,500 a year. If you are older than 50, the limit rises to $22,000 to help you catch up on your retirement savings. In addition to your contributions and your employer match, companies sometimes pay bonuses or offer profit sharing as an additional pre-tax contribution. The total allowable contribution for 2010 is $49,000.

Given the amounts of money in retirement funds, it is important to invest them wisely. Every additional 0.01% return lets you retire nearly a month earlier. Thus fees matter, especially the expense ratio of your plan's fund choices. Most plans have funds laden with fees. Some share this revenue with plan sponsors, enticing them to pick more expensive funds to subsidize the costs of the plan or even make a profit.

But after you retire or leave that company's employment, you should almost always roll your 401(k) into an IRA for better investment choices and lower fees. Few plans have choices in every asset class and subsector.

When trying to craft an allocation when the choices are anemic, start by looking at your top-level asset allocation before selecting specific funds. For example, imagine you have decided on an asset allocation of 8% U.S. bonds, 7% foreign bonds, 34% U.S. stocks, 38% foreign stocks and 13% hard asset stocks. The next step is to look at the choices your plan offers.

You may find three U.S. bond funds and no foreign bond funds. One might be inflation protected, one might be intermediate-term treasuries and the other might be high-yield with a higher than normal expense ratio. You might combine the allocation to U.S. and foreign bonds and then split that amount between the first two bond funds, avoiding the third altogether.

There might be a dozen U.S. stock funds and only two foreign funds. The bulk of your asset allocation may fall in one or both of the foreign funds. And you may have to split the allocation to hard asset stocks between the U.S. and foreign choices. Your financial advisor can help you integrate your 401(k) selections with the rest of your portfolio. And as always, you want to evaluate each choice, looking closely at fees and expenses.

Comments

[webdoyenne]

"If you are older than 50, the limit rises to $22,000 to help you catch up on your retirement savings. In addition to your contributions and your employer match, companies sometimes pay bonuses or offer profit sharing as an additional pre-tax contribution. The total allowable contribution for 2010 is $49,000."

Well, that is more than my salary this year. What BS advice...

[StL Pastor]

That paragraph does start with "if your income is significant." Obviously, if you're not making that much money, you can't contribute that much.
I think this is a nice, clear post, really. Thanks MWM.

[jbhk]

We have seen many these articles about how to max out the retirement savings and open another ROTH account, but what about if you are only making net income $1,000 a month? or net income $4,000 for a family of four? How should they allocate the money in short and long term?

[MBTN]

jbhk:

Here is one possible allocation:

1. First, put money into your 401(k) up until you maximize your company's match (if they have one).
2. If you have money left over from step 1 or if they don't have a match, open a Roth IRA.
3. If you have money left over from step 2, continue to put money into your 401(k).

[Dwight]

Yeah, I agree.

Maxing out your retirement accounts are usually like free money if your employer needs to match your contirbutions. Kudos for the post.

Dwight Anthony
Financially Elite Blog dot Com

[Eddie]

"Today's average worker will have a dozen employers and work at each job for less than four years."

Does anyone know, is this a general statement to illustrate the current times, or is there some research backing up the specific numbers?

[Sunil from The Extra Money Blog]

and for the entreps, def the same with SEP plans. more can be invested in those than employer sponsored 401k type plans, IF you and your business are in the situation to do so

[Jim]

12 jobs average in a life and 4 years per job is about right. BLS.gov says that baby boomers had an average of 11 jobs from age 18 to 44. Current job tenure is 4.4 years median. So this is not a new thing.

[Jim]

jbhk, I would add one point to MBTN's response. For low income people I'd put the money into a Roth 401k if available rather than standard 401k.

Reason being that a family of 4 is taking home $4k after tax then it would seem they'd be in a very low tax rate. $4k take home would mean income around $50k and family of 4 (with 2 child tax credits) would have a tax bill of $750. The single person taking home $1k is in the same boat with maybe a couple hundred in IRs taxes. So in either case they'd have very little taxes to avoid. THey won't get much of any benefit by paying pre-tax money now.

Low income individuals should definitely go with Roth 401k if possible.