The tax-qualified, defined-contribution pension account or 401(k) plan was introduced to help taxpayers benefit from a tax break while doing their retirement savings. Along with tax benefits, this plan comes with the perk of employers contributing money. The 401(k) plan offers investment in mutual funds among others. In fact, a study by Investment Company Institute last year showed that 60% of the $3,565 billion dollars in the 401(k) plan assets belonged to mutual funds in 2012.
Thus, while it is important to know the plan for investors and ways to get the maximum benefits, it is equally important to identify the top ranked mutual funds while saving money in the 401(k) plan. If you don’t find these mutual funds in your 401k plan, you can independently invest in them to maximize your overall return.
The Know-how of 401(k) Plan
Definition: According to the Internal Revenue Service, “A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status) profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan under which an employee can elect to have the employer contribute a portion of the employee’s cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on the employee’s Form 1040, U.S. Individual Income Tax Return”.
In simpler words, a 401(k) plan is a retirement saving plan, much like a pension plan. Named for a section in the tax code, 401(k) plan allows employees to invest a fixed percentage of their salary. The fixed percentage from the salary is deducted before taxes, and no tax is paid until the invested capital is taken out. Employers too must contribute in each employee’s plan. In fact, employers often match up the percentage of investment by the employees.
For example, in 2014, an employee can defer a maximum of $17,500 or 100% of salary, whichever is less. Employees aged more than 50 can make additional “catch-up” contributions of $5,500.
Advantages: As mentioned, a fixed percentage of the salary is parked in the 401(k) plan before taxes. Thus, on a salary of $10,000 per month, an employer may decide to contribute 3% to the 401(k) plan. So the tax is levied on $9,700 and not on the entire salary. Also, an employee is only deferring a certain portion of the salary. These are pre-tax contributions to the plan.
The other major advantage of 401(k) plan is that employers also contribute to the plan. Employers may match up the percentage contributed by employees. So, if an employee is contributing 3% of the salary every month, many employers will contribute the same from their pocket. Thus, it just adds to an employee’s salary, while he is saving money. Usually, a common match is 50% of the first 6% of pay that an employee saves.
The other advantage is that it allows “self-directed investment accounts” along with company stock purchase. Moreover, there is a diversification of investment options. Employees may choose from money market funds, stable value accounts – including guaranteed investment contracts (GICs) or bank deposit accounts, mutual funds or even own company's stocks among others. Diversification lowers the risk.
Gain the Most from 401 (k) Plan
To gain maximum benefits from the plan, there are certain measures that an employee must follow.
Knowing the default savings rate: Employees are often automatically enrolled into the 401(k) plan these days. As a result, 3% of their paychecks are usually deducted and parked in the plan. However, it is crucial to gauge if 3% will be enough to maintain the lifestyle after retirement. A larger share of investment will be prudent. Moreover, employees must increase their investment amount according to their pay hikes.
Full match: Employees must not leave out an opportunity to invest little more when employers offer full match. Usually, employers pay 50 cents for every dollar that is saved up to 6% of the paycheck. If an employee is not investing enough, he automatically loses out on a larger contribution that the company would have made. Company match is free money.
Hang on till vested: To get fully vested in 401(k) plan, an employee may have to work in the same company for about five to six years. Many companies forfeit the entire match if an employee leaves early. So, an employee has to be fully vested in the 401(k) plan to get a match from the employer.
Don’t take cash out often: Employees may switch jobs often and decide to take the cash out from the former employee. Early withdrawal reduces the benefits of compound interest. More importantly, there is a 10% penalty that employees need to pay for withdrawing money from the 401(k) plan before the age of 59.5. An ideal thing to do is do a fee-free transfer. Employees may leave the balance with former employees or roll over the amount to IRA. The former employee may directly transfer the money to new company and that would avoid paying any taxes.
Roth Plan: The 401k option allows fund contribution on post-tax elective deferral basis. However, the benefit is that it offers for tax free growth and distribution given that investment is made for at least 5 years and the employee has reached 59.5 years. It works best for employees who are currently in the low tax bracket, but expects to earn higher salary and thus fall in higher tax bracket later. Once the employee reaches 59.5 years, the withdrawals from the account (including investment gains) are tax-free.
Diversify the investment: Diversification always reduces risk. Investments should be diversified among different instruments like a mix of stock and bond funds. At a later stage of the career, it is best to invest in less volatile mutual funds.
3 Fund Picks
Fidelity, T. Rowe Price and Vanguard are among the behemoths that belong to no-load families. Fidelity Investments is also the largest 401k provider in the nation. Target-date funds are viable options here. Investopedia defines them as “a mutual fund in the hybrid category that automatically resets the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor”. These funds have a target date, as the name suggests. It generally invests 85% to 90% of assets in stocks in the initial years. The stock allocation is later varied as the target date approaches.
Here we will suggest three Zacks Mutual Fund Rank #1 (Strong Buy) funds. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. These funds also have relatively high five-year annualized return rate and have low expense ratio.
T. Rowe Price Retirement 2055 Advisor (PAROX) focuses on capital growth as well as income and seeks highest return over time. The fund parks money in several T. Rowe Price stock and bond funds belonging to different asset classes. The fund invests 90% in stocks and 10% in bonds. The allocation of funds will be modified according to target retirement date. The fund assumes a retirement age of 65 and the specific retirement year is 2055.
The fund has returned 16.6% in the last five years. The fund has an expense ratio of 0.25% as compared to category average of 0.45%.
JPMorgan SmartRetirement 2040 A (SMTAX) seeks high return which may shift to current income and capital growth as the fund nears the target retirement date. It is a fund of funds and invests in underlying J.P. Morgan Funds. This fund is ideal for investors who may retire in 2040. The fund’s asset allocation strategy will change. The fund invests in a range of asset classes.
The fund has returned 16.1% in the last five years. The fund has an expense ratio of 0.29% as compared to category average of 0.53%.
JHancock Retire Living through 2030 1 (JLFOX) seeks total return through target date; following which the fund will focus on income. The fund invests 86% of its assets in underlying funds using the strategy of asset allocation. The asset allocation strategy will become conservative over time. The underlying funds invest in equities. This fund is ideal for investors who may retire in 2030.
The fund has returned 15.3% in the last five years. The fund has an expense ratio of 0.13% as compared to category average of 0.54%.
About Zacks Mutual Fund Rank
By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Learn more about the Zacks Mutual Fund Rank.
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