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7 Ways to Fix a Flawed 401(k) Strategy

Rebecca Lake

Avoid making big mistakes in your retirement savings plan.

Workplace retirement plan investments ballooned in the last decade. The average 401(k) balance increased by more than 450% between 2009 and 2019, according to Fidelity Investments. Meanwhile, the average 401(k) return reflects the stock market volatility of recent years. Vanguard's How America Saves 2019 report found that the median 2018 return was a 6.5% loss, owing chiefly to the uneven stock performance that characterized much of 2018. The average five-year return notched 5.2%. A flawed 401(k) strategy can dampen a retirement outlook, but it's not too late to fix it. Here are seven tips for making the most of investment opportunities inside an employer-sponsored plan.

Clarify investment goals.

Not contributing to a 401(k) at all is arguably the worst mistake workers can make, says Jay Hunt, an institutional retirement consultant for Unified Trust Company. Beyond that, however, a second fatal flaw is not having a clear strategy for investing. "If you don't know what your retirement goal is or have a plan to achieve that goal, there is a high likelihood that you will fail to achieve it," Hunt says. Investors can benefit from reviewing what it is they expect their 401(k) to deliver, in terms of tax advantages, growth over time and eventually, income. Those expectations can then be used to determine which plan investment options are most likely to help reach those targets.

Weigh risk tolerance against risk capacity.

A critical mistake is misjudging the appropriate level of risk to take inside a 401(k) plan. "When you start your first job in your 20s, you can afford to be more aggressive because there isn't much money built up in your account and you won't be retiring any time soon," says Philip Ellis, a financial advisor and CEO of Brittison Financial Group. Leaning on cash and bonds in a workplace plan may appeal to those who are less comfortable taking risks. But risk capacity, or the amount of risk needed to achieve investment goals, might be much higher. Reassessing asset allocation can help determine how wide the gap is and how to narrow it.

Avoid target date fund tunnel vision.

Target date funds, which adjust allocation automatically to fit an investor's target retirement date, hold a widespread appeal among 401(k) investors. According to Vanguard, 97% of plan participants have the option to invest in target date funds. While target date funds have their merits, they're not the only option to consider. Andrew Stewart, a chief investment strategist at Exchange Capital Management, offers a three-point strategy for exploring alternatives. First, determine a target asset allocation. Second, research which funds provide the best access to those asset classes, keeping it as simple as possible. Third, rebalance periodically to adjust allocation over time. "Resist the temptation to trade on your hopes and fears," he says.

Manage tax efficiency.

A 401(k) offers a tax advantaged way to save through deferred growth and it's important to understand what that can mean years down the road. "Although any type of contribution is better than nothing, dumping all available funds into the tax-deferred portion of a retirement account may come back to bite investors later on," says Kyle Whipple, partner at C. Curtis Financial. Investors should consider how tax brackets may evolve as they get closer to retirement and the potential tax consequences of required minimum distributions beginning at age 70.5. This could turn into a tax headache down the road, Whipple says. Investing in a Roth 401(k) instead may be an attractive option to minimize taxes.

Look for hidden risks.

Managing risk goes beyond choosing the right funds to increase diversification. A 401(k) loan can be an under-the-radar threat in more ways than one. The main drawback is that money taken out misses the opportunity to continue growing. "Compounding interest is only impactful if you take advantage of it," says Ariel Fortunato, a strategic advisor at Brown Advisory. In that sense, a 401(k) loan can be just as detrimental as holding onto too much cash in the plan. On the other side of the coin, separating from work with a loan balance outstanding can trigger a taxable event if the loan isn't repaid in full. Avoiding loans is a simple solution, followed by repaying any loans as quickly as possible.

Invest through volatility, not around it.

Uncertainty is the stock market's calling card and 401(k) investors should have a contingency plan for dealing with turbulence. Edward Snyder, a financial advisor and co-founder of Oaktree Financial Advisors, says investors shouldn't steer away from stocks when markets get jumpy. "Market downturns are the exact time you should be investing in stocks because prices are lower." He says workers should ensure that their plan contributions continue buying stocks to take advantage of bargains if share prices drop. Mutual funds that are stock centric, such as the Vanguard Equity Income Fund (VEIPX) or a balanced fund such as Vanguard's Wellington Investor Fund (VWELX), could be good buys for 401(k) investors in volatile times.

Scale up contributions.

Experts agree that leaving free money on the table in the form of an employer match is a mistake. However, investing the bare minimum in an employer's plan that's required to qualify for a matching contribution should be a starting point, not the end goal. Jeffrey Augustine, principal and founder of Augustine Financial Solutions, says workers should be maxing out their plans each year if possible. Automatic contribution increases can make fixing this flaw easier. With automatic increases, contribution rates can adjust automatically each year, ideally coinciding with employee pay raises so the extra money isn't missed. This is a simple, yet an often underutilized method for growing 401(k) investments. "Think of it as a gift to your 65-year-old self," Augustine says.

Use these seven tips to fix a flawed 401(k) strategy:

-- Clarify investment goals.

-- Weigh risk tolerance against risk capacity.

-- Avoid target date fund tunnel vision.

-- Manage tax efficiency.

-- Look for hidden risks.

-- Invest through volatility, not around it.

-- Scale up contributions.

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