When it comes to saving for retirement, few options are better than a 401(k) plan. Where else can you make pretax contributions, get tax-deferred investments and enjoy free money via an employer match?
Despite these advantages, many 401(k) plans aren’t living up to their potential. Whether there are flaws in the structure of the plans themselves or the participants are not optimally managing them, there’s usually room for improvement.
Last updated: Nov. 20, 2020
Improvements You Can Make
Although some improvements to your 401(k) plan can only be made by your employer, there are definite steps you can take to improve your own personal account. By focusing on these short- and long-term solutions, you can vastly improve the quality of your own personal 401(k) account.
1. Rebalance Regularly
Even if you own the best investments in the world, you’re doing your 401(k) a disservice if you don’t rebalance your account regularly. Over time, your asset allocation will almost certainly get out of whack, as certain areas of your account outperform the market and others underperform. If you stick with an out-of-balance allocation, your account will no longer match your investment objectives and risk tolerance. For example, if stocks have a massive 30% rally, you’ll be overexposed to stocks when the next sell-off hits. Then, you’ll likely be underexposed to bonds or other assets that may rally.
“The sooner you take care of adjusting your 401(k) allocation according to your retirement goals and risk tolerance, the better,” said Jon Vlachogiannis, founder of AgentRisk, a wealth management product that uses machine learning in its fund management strategies.
2. Reconcile Your Investment Objectives and Risk Tolerance
Before you can make smart choices with your 401(k) investments, you’ll need to determine what you’re looking to get out of your account. All investors want sky-high returns with no risk, but that’s not always possible or even realistic. It’s important to drill down and determine what you can reasonably expect and how much risk you can honestly handle. For example, if you want a portfolio with maximum growth but get sick to your stomach during a 3% market sell-off, you’ll never be happy with your 401(k) because sell-offs are inevitable. Be realistic about the types of returns you can achieve with the level of risk you’re willing to handle.
3. Review Options Regularly
Just like people, 401(k) plans tend to change over time. If you’ve been with a company for 10 years, chances are your current 401(k) plan looks nothing like it did when you started. Take time to regularly review the options offered by your 401(k) plan, from investment choices to changes with your employer match or vesting schedule.
“Obsessing over your investment accounts is a one-way street to losing money,” Vlachogiannis said. “On the other hand, markets change and evolve and portfolios built 10 years ago might not be relevant today. You should at least re-evaluate every year the allocation of your 401k, the fees that you are paying and how it fits the rest of your financial portfolio.”
4. Increase Your Contributions
What’s one of the best ways to make a good thing better? Get more of it! Many employees can’t contribute the maximum to their 401(k)s when they first start. In 2020, for example, the maximum 401(k) contribution allowed for employees will be $19,500. If you’re earning $50,000 a year, putting away nearly $20,000 into a 401(k) plan might be unrealistic. However, if you start out contributing 5% of your income to your plan, try increasing that amount by 1% every month, quarter or year. The additional 1% on a $50,000 salary only amounts to about $41.67 per month, so you might not even notice the change from a cash-flow perspective — but your 401(k) balance will benefit tremendously over the long haul.
5. Use a Portfolio Perspective
Over time, your 401(k) plan might grow to become your largest single investment — but it shouldn’t be your only one. Ideally, you’ll have investments beyond your 401(k) plan, including a regular taxable investment account that also includes stocks, bonds and other assets. It’s important to view your 401(k) allocation as part of your overall investment strategy.
For example, if you are heavily loaded in stocks in your regular investment account, you might want to balance your portfolio by leaning toward bonds and other less-risky choices in your 401(k). Similarly, if your 401(k) is loaded up with company stocks, you might want to diversify some of that risk away in your taxable investment account.
6. Don’t Touch It Early
First and foremost, a 401(k) is a long-term retirement plan. You shouldn’t be taking money out of it during your peak earning years — you should be adding more to it. For starters, any money you take out of your 401(k) plan prematurely won’t have the chance to compound and generate gains over time. But early withdrawals don’t just shrink your long-term nest egg. With few exceptions, if you withdraw money from your 401(k) before you turn 59 1/2, you’ll owe ordinary income tax and also face a 10% early withdrawal penalty on that money. For some taxpayers, that could amount to nearly 50% of their 401(k) withdrawal. You can’t optimize your 401(k) by taking money out of it before you retire.
7. Invest Regularly
One of the many structural benefits of a 401(k) is that you can invest regularly. Every time you receive a paycheck, a portion of that money can be contributed to your plan. Sticking to a regular investment schedule is a great way to tame the damage caused by the occasional, but inevitable, market pullbacks. Some of your contributions will go in when the market is high, while others will go in while the market is low. But over time, they should average out somewhere in the middle.
8. Don’t Pull Out During Downturns
Along the lines of “invest regularly”: It’s important to keep your money invested in your 401(k) even during market sell-offs. Remember that over the long haul, market ups and downs translate into a relatively smooth trendline. If you sell out of your 401(k) during a market pullback, it can be difficult to know when to get back in. If the market viciously snaps back — as it often does — you might miss out on a huge amount of gains. Studies bear this out. According to Fidelity, if you missed just the top 10 days in the market in the 38 years between 1980 and 2018, your initial investment of $10,000 would be worth $341,520 less than it could have been.
9. Reduce Risk as You Approach Retirement
A 401(k) isn’t a “set-and-forget” investment option. As you approach retirement, you should reduce your risk level. This can help prevent a massive loss in value if the market collapses right before you withdraw your money. If you’re reviewing your portfolio regularly, as you should be, this won’t be an extra step. But if you find yourself in the position of nearing retirement already, it’s time to review your 401(k) allocation and make sure a large portion of it is in safe investments, such as bonds and money market funds.
10. Roll Your 401(k) Over
Just because you leave your job doesn’t mean you have to leave your 401(k) plan behind. If your new employer offers a better 401(k) plan, you have every right to roll your old plan over into your new plan. Of course, it’s not a given that your new plan will be any better than your old plan. In that case, check with your old employer to see if you can leave your plan there. In many cases, you’ll be able to, though you might have to pay extra fees. It’s actually a nice position to be in from an investment standpoint because you can choose the best option from two plans. Just bear in mind that if you leave your 401(k) with your old employer, you’ll no longer be able to make any payroll deduction contributions and you obviously won’t get matching contributions from your former employer.
11. Use Catch-Up Contributions
As if the standard benefits of a 401(k) aren’t enough, the IRS also lets you make additional contributions once you reach age 50. Known as “catch-up” contributions, these extra deposits can help those near retirement age quickly boost their account values. For 2020, if you’re 50 or older you can contribute an additional $6,500, for a total of $26,000. This is a great way for older participants to improve their 401(k) plans.
12. Have Your Plan Reviewed by Your Financial Advisor
Don’t make the mistake of regarding your 401(k) plan as just a collection of mutual funds you invest in at work. Your 401(k) plan investment strategy should be an integral part of your overall financial planning. To that end, you might want to work with a financial advisor to review your 401(k) and make suggestions on how to improve it. Since it can be challenging to integrate your 401(k) with your other investments, having the benefit of a professional’s eye can be a good way to help improve your 401(k).
13. Don’t Rely On Target-Date Funds
In some 401(k) plans, target-date funds dominate the available options. Target-date funds automatically allocate your funds based on your age, shifting from more aggressive portfolios in your 20s and 30s to more conservative portfolios as you approach retirement. While sound in principle, target-date funds might not be customized to your own personal investment objectives and risk tolerance. For example, if you already have conservative investments in your taxable investment account, you might not need to be super conservative in your 401(k) even as you near retirement age.
14. Don’t Own Too Much Company Stock
Many employers offer company stock in their 401(k) plans and many encourage employees to own a lot of it. Additionally, certain company bonuses or other retirement incentives that are paid in stock often get deposited into company 401(k) plans. This further increases participant allocations to company stock. Many advisors recommend that 401(k) participants trim the amount of company stock in their plans for diversification purposes.
Think about it: You’ve already hitched your wagon to the value of your company in many ways, including your job and your insurance. If the company hits hard times, you might not only lose your job and your insurance but the value of your 401(k) as well. For this reason alone, it’s a good idea to diversify away from holding too much company stock in your 401(k).
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15. Don’t Overtrade
This bit of advice also applies to your other investment accounts, but it’s particularly applicable to your 401(k) plan. If you overtrade your 401(k) and try to time the market, you’ll likely miss out on a lot of big up days. Plus, when you trade a lot, you’re invalidating all the hard work you did when you defined your investment objectives, risk tolerance and created an appropriate portfolio for your long-term goals. Think of your 401(k) account as the long-term retirement plan that it is — not a game.
16. Maximize Your Tax Benefits
No matter how you invest your 401(k), when you finally take your money out it’s all taxable as ordinary income. This means you’ll pay the same tax rate on your 401(k) withdrawal as you do on your normal salary or wages. This is a huge disadvantage because it increases the tax you pay if you have long-term gains in stocks. If you invest in stocks in a taxable investment account and hold them for at least one year, for example, you’ll typically only pay somewhere between 0% and 15% on those gains.
With your 401(k), however, you might end up paying much more, depending on your income tax bracket. Because of this, consider emphasizing income-generating investments like bonds in your 401(k) over capital gains investments like stocks. Consult your financial and tax advisors for help.
17. Take Advantage of Automation
It’s hard for many Americans to stick to a savings plan, as evidenced by a recent GOBankingRates survey that found 58% of respondents said they have less than $1,000 saved for emergencies. You can turn your 401(k) plan into a savings powerhouse by automating your contributions.
“The easiest automation is setting up automated deposits to your 401(k), directly from your paycheck,” Vlachogiannis said. “This is a no-brainer and it is a must-have for everyone.”
Once you activate the automatic features of your 401(k), you’ll be saving money every pay period without having to think about it.
18. Go To Your Annual Meeting
Companies typically have annual meetings to explain the features and benefits of their 401(k) plans. It’s important to attend these meetings if you want to maximize the performance of your 401(k) plan. Use this time to ask questions about the plan, including some of the ones listed below that highlight how employers can improve their 401(k) plans. Keep an eye out for any 401(k) plan changes that your employer might implement in the coming year as they could be enhancements — or drawbacks — that you should be aware of.
19. Avoid High-Cost Investments
As an employee, you might not have much say in which 401(k) provider your employer uses. But you do have complete control over your own investments. Just like with a regular investment account, some investments are more expensive than others. For example, check out the expense ratios of any mutual funds or ETFs you might want to put in your portfolio and compare them with available alternatives. All things being equal, you’ll want to choose the most inexpensive fund. Over the 20, 30 or 40 years you contribute to your 401(k) plan these seemingly small expenses can add up.
Improvements Your Employer Can Make
Some improvements to a 401(k) plan are beyond your reach as an employee — only your company can implement them. However, you can suggest changes to your employer in a meeting if those changes ultimately benefit the entire company by improving the 401(k) plan.
1. Reduce Program Fees
You might be aware that your 401(k) charges fees, but you’re probably unaware of how much. Although your employer likely pays the bulk of these costs, if not all of them, it can still hurt your benefits as an employee. The less money your employer keeps, the less it has to pay out in the form of benefits and a 401(k) match. Considering how competitive the 401(k) landscape is, there’s no reason your employer should work with a provider that charges high fees. If you find out that’s the case, you might want to recommend other providers with lower fees.
2. Increase Investment Options
Just like high fees are a hallmark of a poor 401(k), so too are limited investment options. When 401(k) plans first came into being they only offered a handful of mutual funds to participants. Nowadays, good 401(k) plans have a broad range of funds to choose from, with multiple fund families participating. Some 401(k) plans even allow self-directed stock investments. While you shouldn’t ask for more funds just for the sake of having them, the more options you have to choose from, the more likely you are to find good choices that match your investment objectives and risk tolerance.
3. Institute a Loan Program
The IRS allows 401(k) plans to offer loans, but not all employers do. In a perfect world, you would never touch your 401(k) balance. And while you really shouldn’t — except in financial emergencies — there might be times when having the option to take a short-term loan from your 401(k) can be a good thing. Usually, you can borrow the lesser of $50,000 or half of your vested plan balance when you take out a 401(k) loan. While that should never be your first option for a source of funds, at least you’ll be paying the interest on your 401(k) loan back to yourself.
4. Increase Your Company Match
One of the hallmarks of a good 401(k) plan is the company match, which amounts to free money for your retirement. Typically, employers will match a certain percentage of your 401(k) contribution and deposit it in your account on your behalf. If your employer has no match, instituting one is a guaranteed way to improve your 401(k) plan. Of course, this costs the employer money but it gets a tax write-off for its contributions, and a match makes the plan more competitive. At a time when unemployment is at an all-time low, you can make the pitch to your employer that it will attract more high-quality talent with a first-rate employer match.
5. Offer a Roth 401(k)
Roth 401(k) plans are a relatively new entrant into the world of retirement plans, but tax-wise they function just like a Roth IRA. With a Roth 401(k), you don’t get a deduction for your contributions but you can withdraw money from the account tax-free. This is a good option if you’re currently in a low tax bracket but anticipate being in a higher one at retirement. Whether or not you intend to use this option immediately, it’s a good way to improve the overall offerings of your employer’s 401(k) plan.
6. Implement/Improve Online and Mobile Account Management
The 401(k) plan was created by an Act of Congress: the Revenue Act of 1978. In those days, online and mobile account management were futuristic dreams. Nowadays, nearly every type of account available, from checking and savings accounts to investment accounts, can be managed from a computer or a smartphone. This access, however, hasn’t always translated over to 401(k) plans. If you don’t have the same electronic access to your 401(k) plan that you do with your checking account, talk to your employer about modernizing your plan.
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