Basics: Laying the Groundwork for a Secure Retirement | Planning
Lesson 1: What's So Special About 401(k)
The Power of Investing with Your 401(k) Plan
It is amazing how just a little knowledge and effort can
literally change your life -- especially when it comes to
personal financial planning. The 401(k), a private-sector,
employer-sponsored retirement savings plan, is one of the
simplest, most painless, and most effective ways to ensure
your future financial security. This course will help you
to master the basics of 401(k) plans and to take one of the
most important steps toward a secure retirement.
Why don't more people take advantage of 401(k) plans? I
blame the name. "401(k)" sounds like a cross between
a boring breakfast cereal and a graduate-level accounting
course. If it were named "How to get free money from
the government and from your employer and invest it for your
retirement" plan, maybe more of us would already be
lounging on a beach somewhere, secure in the knowledge of
a bright financial future.
Before we tackle the rules and regulations of 401(k) plans,
let's examine the potential rewards of 401(k) investing,
as shown in Figure 1-1.
Fig 1-1: 401(k) plans can add up.
Are 401(k) Plans Better?
Are 401(k) plans better than conventional investment plans
or IRAs? We can look at a simple example to address this
question. In our example, four brothers all work at the same
company, each making $50,000 a year. Each brother puts 6
percent of his salary toward retirement, but each invests
using a different retirement strategy.
Kevin uses a traditional investment plan. His funds are
invested in assets that, on average, return 6 percent a year.
Keith uses an IRA account. His funds are invested in assets
that, on average, return 6 percent a year.
Ken invests in his company's 401(k) plan. His funds are
invested in assets that, on average, return 6 percent a year.
Kyle invests in his company's 401(k) plan. His funds are
invested in assets that, on average return 12 percent a year.
Fig 1-2: This shows the brothers' retirement funds after
just 10 years.
The chart in Figure 1-2 demonstrates
the sizeable tax advantages that 401(k) and IRA plans offer
All the calculations assume that the savings contribution
is made at the end of each year.
Just look at poor Kevin. He puts aside as much as his brothers
do. Nevertheless, without the advantage of pretax contributions
and tax deferral of his investment income, he just does not
get the same powerful results.
Why are the brothers' investment results so radically different?
The next page summarizes the important features of the different
investment strategies that contribute to the very different
outcomes for each brother.
Some Important Features
Four key features of a 401(k) plan that set it apart from
other investing options and lead to higher retirement savings
Let's look at each in more detail.
The U.S. Tax Code allows pre-tax contributions into 401(k)
and IRA plans. This means that the portion of your salary
that goes into these plans is not taxed as income. The main
difference between IRAs and 401(k)s is that an IRA is an
individual account that you set up and control, while your
employer sponsors and contributes to a 401(k).
In our example, each brother invests $3,000 a year toward
his retirement (you may invest up to $3,000 before age 50
and $3,500 after age 50, in an IRA). Kevin, who is not using
a 401(k) or IRA plan, must pay taxes on that $3,000. That
means that if Kevin were in the 28 percent tax bracket, his
real investment, after Uncle Sam received his dues, would
only be $2,160 a year. And if Kevin were in a higher tax
bracket, his net investment would be even less.
Keith, Ken, and Kyle, on the other hand, have all taken
advantage of IRA and 401(k) tax breaks. All their investments
are pretax, so when they pay their annual taxes, the full
amount is invested in their respective IRA or 401(k) plans.
They also get a second break: Unlike Kevin, who has to cough
up taxes on his full $50,000 salary, Keith, Ken and Kyle
only have to pay taxes on $47,000: their salary minus their
retirement plan contributions.
So now the decision should be a simple one: Do you give
the government those extra tax dollars, or do you invest
them for your retirement?
There are limits on the size of your annual pretax contributions
-- and they are different for IRAs and 401(k)s. These regulations
will be covered in Lesson 2.
Tax deferrals, another benefit of 401(k) and IRA plans,
allow you to postpone paying income tax on the dividends
your investments earn until you withdraw money from the accounts.
So when Kevin earns 6 percent on his investments in the
form of interest, dividends, or capital gains, he must pay
taxes on those earnings the same year it is earned.
Because IRAs and 401(k)s are tax-deferred plans, Keith, Ken, and Kyle
are able to keep money working in their retirement fund that they otherwise
would have paid in taxes. For more information on tax deferrals, see
A Commonsense Guide to Your 401(k), Step 9.
So tax deferrals and pretax contributions explain why Ken,
Kyle, and Keith are besting Kevin. So, what explains why
Ken and Kyle, who both invest in 401(k)s, are doing so much
better than IRA-investing Keith is?
Almost all employers offer a matching-funds feature with
their 401(k) plans. For every dollar an individual contributes
into a 401(k) plan, the employer also contributes some portion
of a dollar into the employee's account.
In our example, Ken and Kyle receive 50 cents (50 percent)
from their employer for every dollar they contribute into
their 401(k) plan -- or $1,500 dollars a year -- of free
Most companies put a limit on their matching funds. For
instance, many companies offer a 50 percent match for contributions
up to 6 percent of the employee's salary. If Ken and Kyle
contributed $3,000 a year, or 6 percent of their salary,
they would receive $1,500 in matching funds from their employer.
If they contributed $4,000 a year, or 8 percent of their
salary, they would still only receive $1,500 in matching
Some companies offer a graded or graduated matching program.
They may contribute $1 in matching funds for every $1 of
contributions up to 2 percent of an employee's salary, and
a 50-cent match for every $1 of contributions for the next
4 percent. Understanding the terms of your employer's 401(k)
matching plan is one of the most important things you can
do. A 401(k) employer match is free money waiting for you
to claim it. One of your goals should be to try to contribute
enough money to your 401(k) plan to get the maximum amount
of "free" employer matching funds. You may not
always be able to do this -- especially at the beginning
-- but you should always give it your best shot. For more
information on employer matching see A Commonsense Guide
to Your 401(k), Step 27.
We will devote a whole lesson to 401(k) investments, but
it is important to note that the only difference between
Ken and Kyle's investment plans is the type of investments
they made within their respective 401(k) accounts. Most 401(k)
plans offer at least three different investment options --
but some plans can offer dozens.
Have you ever heard the expression "No Pain, No Gain?" Although
the phrase is mostly associated with exercise, there is a
parallel truism in the investing world: "No Risk, No
Return." Often, the investments with the biggest returns
are the riskiest. If you have a long time until your retirement,
you are more likely to see riskier, more aggressive investments
pay off. But investing isn't just an exercise for the mind
-- sometimes it's an exercise for the stomach. If your investments
keep you up worrying at night, it doesn't matter what your
eventual return is. To invest your 401(k) funds comfortably,
you need to know about the investment options in your 401(k)
plan -- and you need to know a little bit about your tolerance
for risk. Kyle, whose 401(k) plan invests in higher-return,
riskier stocks than Ken's more conservative plan, has a higher
risk tolerance than his brother.
Time is on Your Side
Time is another important feature of retirement investing.
Time is the retirement plan's best friend. Let's take another
look at our four brothers' nest eggs after 10 years and again
after 30 years (Figure 1-3).
Fig 1-3: Retirement funds after 10
and 30 years.
Wow! You might expect the brothers to do three times better,
because 30 years is three times longer. But all the brothers
have done much better than that. Why? The answer lies in
the power of compound interest. As Mary Rowland notes in
the course text, Albert
Einstein called the compounding of interest the greatest mathematical
discovery of all time.
In the gambling vernacular, compounding is the equivalent
of "letting it ride." In other words, it's the
benefit you get by reinvesting your investment earnings and
accruing interest over and above the interest you would earn
on your original investment. The longer you let your earnings
ride, the more benefit you receive from compound interest.
While all of the brothers benefit from compounding, Keith,
Ken, and Kyle all receive greater benefits from compounding.
Why? Because of the tax deferral of IRAs and 401(k) earnings,
they are able to let all their earnings get reinvested. Kevin
has to pay taxes on his earnings and has less to reinvest.
Kyle is the biggest winner from compounding. The tax advantages
of his 401(k) plan, his employer match, and his aggressive
investments have put Kyle on the fastest track to a secure
More about Compounding
For more detailed information on how you can make compounding
work for you read A Commonsense Guide to Your 401(k), Step
10. for a quick way to calculate how fast you can double
your money with compounding, pay particular attention to
the "Rule of 72".
You Can Get Kyle's Results -- Don't Settle For Kevin's
Kevin and Kyle put the same amount of money aside each year.
However, after 30 years, Kyle has almost 6 1/2 times more
money in his retirement account. And the truth is, you may
be able to do even better than Kyle. The scenario in this
lesson uses a very moderate rate of contribution. In addition,
for simplicity, we assume that Kyle never got a raise in
30 years. Nevertheless, our example still shows that even
modest contributions to a 401(k) can achieve powerful results.
Learning how to get the most out of 401(k) investing is
not hard -- and just look at the difference it can make in
your life. In the next lesson, you will learn everything
you need to know about joining and contributing to a 401(k)
Read "Part 1: The Retirement Landscape" in Mary Rowland's A
Commonsense Guide to Your 401(k). This will start you thinking about
your retirement needs and what resources are available to get you there.
Quiz1: Lesson 1, Quiz 1
Answer the following questions about this lesson.
Which of the following set 401(k) plans apart from other
- Employers often match employee contributions
- The contributions are made pre-tax
- You can postpone paying taxes on the dividends your
401(k) account earns until you withdraw the money
- You do not have any investment options.
True or False: 401(k) programs are company-sponsored while
IRAs are setup and managed by individuals.
If you are under the age of 50 what is the maximum amount
you can contribute to an IRA in any year?
True or False: To benefit from compounding you need to let
your money ride for as long as possible.
True or False: You get greater benefits from compounding
if you use a traditional investment plan instead of a 401(k)
Quiz1: Lesson 1, Quiz 1 Answers
1. A. B. C.
3. C -$3,000
401(k) Basics: Laying the Groundwork
for a Secure Retirement
Lesson 2: Contributing to Your 401(k) Plan
Who Can Contribute?
Employers who offer 401(k) plans may limit employee eligibility
in two major ways. The two eligibility requirements are age
and the amount of time an employee has worked at the company.
Your employer can legally set a minimum age requirement
for eligibility to participate in its 401(k) plan. For instance,
a company may say that an employee must be at least 19 years
old to participate. However, government regulations stipulate
that all employees 21 and older are eligible to participate
in 401(k)s, if an employer offers one. This means that your
employer cannot exclude you from participating in a 401(k)
if you are older than 21.
Year of Service Requirement
Your employer can also require that you work for the company
a minimum amount of time before you are eligible to participate
in its 401(k) plan. The government has set a maximum amount
of time an employer can specify as one year of service. For
full-time employees, this requirement is straightforward
-- if you have met the age requirement, your company must
allow you to participate in its 401(k) no more than a year
from the date you were hired. For part-time employees, the
formula is more complicated.
The government defines one year of service as the 12-month
period beginning on the first day of employment. The catch
is that employees who meet the one-year requirement must
work at least 1,000 hours in those 12 months (roughly half-time).
If you work less than 1,000 hours a year, your employer does
not have to let you participate in its 401(k) plan.
Why Not Everyone?
Why doesn't your company let all its employees participate
in its 401(k) plan? Chances are it is not because they are
cheap or cruel – it is most likely related to what
the government calls the "non-discrimination test."
This government-imposed test makes sure that companies do
not design 401(k) plans just for the high-income crowd. It
makes sure that lower-income workers participate at rates
similar to high-income workers. If lower-income workers are
contributing far less of their salary than high-income workers,
the employer either has to lower the participation amount
of the high-income workers, or face disqualification of their
plan by the government. If the government disqualifies a
401(k) plan, the plan loses all tax advantages for both the
employer and the employees.
Workers under the age of 21 and workers working less than
half-time traditionally participate in retirement savings
plans at lower rates than other employees do. Let's face
it: when you were 19, you probably were not socking away
10 percent of your salary for retirement -- although think
of how easy life would be now if you had. Setting age and
service limits allow employers to protect their low-income
participation rates from being too low.
What Are Your Employer's Eligibility Requirements?
Now that you know what the government's requirements are,
you may be pleasantly surprised to see that your employer's
eligibility requirements are far more lenient. The very first
thing you should do after this lesson is to learn the details
of your employer's eligibility requirements.
When you are ready to dive in to your employer's 401(k)
plan, the two most important documents you should read are
- The Summary Plan Description (SPD), which details the
- Eligibility requirements
- Investment options
- Employer contribution limits
- Employer match information
- Plan options, such as loan provisions
- The Summary of Material Modifications, which is just
a summary of changes made to your plan since the company
last published the SPD.
Your Human Resources (HR) department is a good place to
start. If they do not have the information you need, they
will direct you to someone who does. Some companies even
keep this material online on a company Intranet or file server.
The government has established pre-tax contribution limits
to 401(k)s. Your company also sets contributions limits,
which may be the same as or tighter than the government's.
Why does the government care how much tax-free income you
contribute to your retirement? Because you are investing
with their tax dollars! Remember from Lesson 1 that you do
not have to pay taxes on your 401(k) contributions. This
means that the more you contribute, the fewer tax dollars
the government gets. Although the government is interested
in helping you retire, it is also interested in staying solvent.
So there is a limit on just how much help Uncle Sam is willing
In 2002, the most "pre-tax" money an individual
can contribute is $11,000. This is true even if you work
for more than one employer. This amount may change year to
year, depending on inflation. It varies according to Section
402(g) of the Tax Code. The government also limits the total
annual contribution that all combined sources -- including
your "pre-tax" contributions, your employer's contributions,
profit-sharing contributions, and after-tax contributions
-- can add to your 401(k) account. The limit for 2002 is
the lesser of $40,000 or 25 percent of your total compensation.
In other words, if your compensation is $100,000 per year,
your total 401(k) contributions cannot exceed $25,000. If
your income is $200,000, your 401(k) limit is $40,000. If
you are interested in Tax Code implications, Section 415
of the Tax Code governs the limits.
Why doesn't your company just use government limits? The
main reason is to ensure that it does not exceed government
limits. If a company exceeds those limits, its 401(k) plan
will lose its all-important tax-exempt status. The other
reason relates to the "non-discrimination test." If
your company has had trouble with high-income workers contributing
a higher percentage of their salaries than lower-income workers
have, they may place a limit on the percentage of your salary
you can contribute.
What Are Your Employer's Contribution Limits?
You company's SPD details your contribution limits and specifies
how your employer matches your contributions in the SPD.
(Employer matches were discussed in Lesson 1.) The government
does not require that employers provide matching funds, but
the majority of employers do. Your SPD will tell you how
much of your contribution is matched by your employer and
if there is a limit on the amount or percent of your salary
that is matched. The bottom line is that any match is free
-- and better yet, tax-free -- money from your employer.
You may be able to contribute more than the pre-tax contribution
limit -- but you would have to claim this money as taxable
income. Why would you consider doing this? Well, even though
the contributions are not pre-tax, your investment earnings
are still tax-deferred. If you need to save more for your
retirement and you already contribute the maximum pre-tax
amount allowed, after-tax contributions might be a good option
You should consider some things before heading down
- Not all 401(k) plans allow after-tax contributions --
only about half do.
- Even if your plan allows after-tax contributions, there
are still government and employer contribution limits.
- It is unlikely that your company will offer employer
matching of after-tax contributions.
- You cannot borrow against after-tax contributions. Many
401(k) plans let you borrow against pre-tax contributions
-- something we will cover in Lesson 3.
- You can withdraw after-tax contributions without paying
tax on them -- since you have already paid taxes on them
-- BUT you will be subject to withholding on the earnings
made from those contributions, which may also be subject
to a 10 percent withdrawal penalty if you are not yet 59
- After-tax contributions are not eligible for rollover
into an IRA.
If you are not at your pre-tax contribution limit, do not
waste your time or money thinking about after-tax contributions.
If you are at the pre-tax limit, and you know you have to
do more for your retirement, you should consider after-tax
contributions. Just be sure you also understand your other
options, which may include a regular IRA, Roth IRA, nondeductible
IRA, annuity, or just taxable investing. For a discussion
of after-tax contributions, see Step 31 of A Commonsense
Guide to Your 401(k).
401(k)s: How They Affect Your IRA Contribution
If you contribute to your 401(k) plan, it may affect the
tax-deductible investments you can make in an IRA account.
Any effect you might see depends entirely on your adjusted
gross income (AGI).
In 2002, if you participate in a 401(k) or a SEP IRA, and
are single, the following rules apply:
- If your AGI is less than $34,000, then a $3,000 IRA contribution
is fully tax-deductible.
- If your AGI is more than $44,000, then your IRA contribution
is not tax-deductible.
- If your AGI is between $34,000 and $44,000, you are
allowed a tax-deductible IRA contribution of less than
$3,000 ($3,500 if over 50) with the specific amount determined
by the formula discussed at the end of this page.
In 2002, if you and your spouse participate in a 401(k)
or SEP IRA, the following rules apply:
- f your total AGI is less than $54,000, then your $3,000
($3,500 if over 50) IRA contributions are fully tax-deductible.
- If your total AGI is more than $64,000, then your IRA
contributions are not tax-deductible.
- If your total AGI is between $54,000 and $64,000, you
are allowed tax-deductible IRA contributions of less than
$3,000 ($3,500 if over 50) with the specific amount determined
by the formula at the end of the page.
In 2002, if either you or your spouse (but not both) participate
in a 401(k) or SEP IRA, the following rules apply:
- If your total AGI is less than $150,000, then the non-covered
spouse's $3,000 ($3,500 if over 50) IRA contribution is
- If your total AGI is more than $160,000, the non-covered
spouse's IRA contribution is not tax-deductible.
- If your total AGI is between $150,000 and $160,000,
the non-covered spouse is allowed a tax-deductible contribution
of less than $3,000 ($3,500 if over 50), with the specific
amount determined by the formula at the end of the page.
You may also choose to make annual non-deductible IRA contributions
if the deductible ones are not allowed. The same caps apply:
$3,000 or $3,500 if over 50 years of age. Why would you want
to do so? Some people like to keep all of their savings in
one place, rather than in separate IRA and taxable investment
accounts. Moreover, the benefits of tax deferral on investment
gains within an IRA are substantial.
The down side? You must file and retain a copy of IRS Form
8606 for every year that you make a non-deductible contribution,
which can be a little cumbersome. Most advisors feel the
cons outweigh the pros when it comes to non-deductible IRA
Partial Deduction Formula
If your AIG is "between" the deductible and non-deductible
amounts, you can calculate your new tax-deductible contribution
amount by using the following:
- Take the higher amount in the range provided (i.e.,
$44,000 if you are single) and subtract your AGI.
- Multiply the number you get by .20 (or 20 percent).
If the result is not a multiple of $10, round it up to
the highest multiple of $10. For example, $470.50 rounds
up to $480.00. This is your tax-deductible IRA contribution
limit -- unless your answer is less than $200. If your
result is less than $200, but more than $0, you are allowed
a $200 tax-deductible IRA contribution.
Changing Your 401(k) Contribution Amount
By the end of this class, many of you will be very organized,
have run budget analyses, and come up with the perfect 401(k)
contribution amount consistent with your current financial
needs and future retirement needs. Then again, many of you
will be like me.
You will want to do the right thing by contributing the
most money you can for retirement -- but it is hard to know
what you can really live with. On the other hand, you may
decide on a contribution amount, but then find out that the
twins need braces.
One of the nice things about 401(k) plans is that companies
make it easy to change the contribution amount. Most companies
allow you to make changes on a monthly basis. Some may require
you to fill out a form, but many have an automated telephone
or online system to address changes. To find out how often
you can make changes to your contribution amount, look in
I do not recommend that you go in there every month tweaking
the amount. What I do recommend is that when you first pick
a contribution amount -- err a little on the high side. Be
aggressive with your contributions. You can always reduce
them if you need to.
Did you make it through today? Congratulations. This lesson
covered many of the details. However, if you've gotten this
far, the rest isn't hard at all. The next lesson will cover
how to get your money out of your 401(k) when you need it.
Besides, it is a lot more fun to study how to take money
out than how to invest it.
Get a copy of your company's Summary Plan Description (SPD) and find
the following information:
- Your company's 401(k) eligibility rules
- Your company's 401(k) contributions limits
- How your company's employer match works, if it has one
Quiz1: Lesson 2, Quiz 1
Answer the following questions about this lesson.
Which of the following two eligibility requirements may
limit who can contribute to your company's 401(k) plan?
- Base salary
- Amount of time employed
- Age until retirement
True or False: If you work less than 1,000 hours a year
your employer is not required to let you participate in its
True or False: Your employer's 401(k) eligibility requirements
must match those of the government.
A company's Summary Plan Description (SPD) will include
information on: (Check all that apply.)
- Your investment options
- Contribution limits
- Eligibility requirements
- Any updates that may have been made to the plan since
the SPD was published.
How much pre-tax income can you contribute to a 401(k)
True or False: Once you reach your yearly pre-tax contribution
limit, you can not contribute any more money to your 401(k).
True or False: After you set up your initial 401(k) contribution
amount you can't change it.
Quiz2: Lesson 1, Quiz 1 Answers
- B, C.
- C, $11,000
401(k) Basics: Laying the Groundwork for a Secure Retirement
Lesson 3: Getting Money Out of Your 401(k) Before
Introduction to Withdrawals
401(k) plans are not deep holes where money disappears until
far in the future. However, anxiety about access keeps many
people from taking advantage of 401(k) plans. In fact, there
are limitations on how and when you can use the money. In
most cases, if you withdraw funds from you 401(k) funds before
you are 59 1/2 the withdrawal might be difficult and will
almost certainly result in a 10 percent early-withdrawal
penalty. Nevertheless, there may be ways to get to your 401(k)
funds early, and in some cases, without penalty, if you really
It is not necessarily a bad thing that early 401(k) withdrawals
are difficult. It means that you cannot take money out on
a whim, and it increases the chances that you will have the
financial base you need when you retire.
Even so, stuff happens, and there are times when accessing
your money now is far more important than saving it. For
instance, your spouse may develop a terminal disease, and
insurance will not cover the one treatment that may bring
hope. Alternatively, you may have a variable-rate mortgage.
If interest rates rise to a point so that you cannot cover
the mortgage, and the bank is about to foreclose, you should
access your 401(k) savings immediately.
In addition, there are also more routine reasons why you
may want to divest from a given company's 401(k) plan. You
may leave your job for a better one. Transfer of your 401(k)
funds is easy enough to do, but you should know a few things
about the timing of the transfer.
Finally, there is death. Obviously, you will not be withdrawing
the funds -- but your near and dear will. It is important
to think about how to make the process as tax-advantaged
and hassle-free as possible.
Huge medical expenses have eliminated your cash, but you
have a million dollars in your 401(k), just sitting there.
What can you do? Most company 401(k) plans let you withdraw
funds in case of hardship. If your plan allows hardship withdrawals,
the Summary Plan Description outlines the specifics. The
government defines hardship circumstances as follows:
- Unreimbursed medical expenses for you, your spouse, or
- College tuition and expenses for the coming year; qualifying
expenses are tuition fees, and room and board for you,
your spouse, or your dependents
- A down payment on your primary residence
- The need to avert an eviction from or foreclosure on
your primary residence
These hardship withdrawals are predicated on the premise
that you have no other resources available. If you need to
make a hardship withdrawal, you must be prepared to offer
evidence that the hardship exists and that you have no other
financial avenues available to you. This may include providing
a list of bank accounts, insurance policies, investment accounts,
Before you make that hardship withdrawal, you need to know
that your withdrawal is subject to a 20 percent withholding
tax. In addition, if you are under age 59 1/2, you may also
be subject to the 10 percent early withdrawal penalty. However,
you may avoid this penalty, if:
- Your unreimbursed medical expenses exceed 7.5 percent
of you adjusted gross income
- You are totally disabled
- You no longer work for the company that runs the 401(k)
and left in or after the year you turned 55
- You will be unable to make any contributions to your
401(k) plan for the next year
Hardship withdrawals are intended as a last resort -- and
that is the only time you should consider one. For more information
on hardship withdrawals, see A Commonsense Guide to Your
401(k), Step 23.
Out the Back Door
Having trouble with the hardship withdrawal? There may be
another way to access funds. Your company may have an "in-service
withdrawal option" that would allow you to move your
401(k) funds into an IRA. To get money out of an IRA, you
do not have to prove hardship; you can simply make the withdrawal.
You will have to pay taxes on it, but if you are under age
59 1/2, the IRA will waive the 10 percent penalty if your
expenses are for:
- Health insurance premiums if you are unemployed
- Higher education expenses incurred for the coming year
- First home purchases ($10,000 lifetime limit)
For more information on other ways of getting money out
of your 401(k), see A Commonsense Guide to Your 401(k), Step
If you really need the cash now, a loan from your 401(k)
may be the best route. Again, although not all companies
are required to offer this service, the vast majority of
them do. How do you know if your plan has a loan feature?
Again, it will be in your SD.
How Does It Work?
Most companies set a limit on the amount you can borrow
from your 401(k). Most company plans allow you to borrow
up to 50 percent of your available funds, with a maximum
amount of $50,000. Most companies also have competitive interest
rates associated with these loans. By law, however, they
cannot offer below-market rates.
Most of these loans are limited to a five-year period, although
some provide home loans with a longer duration. The best
thing about borrowing from your 401(k) rather than a bank
is that when you pay back the interest, you pay it back to
your account. In other words, you pay yourself back for the
loan you made yourself. Sounds great, doesn't it? However,
as with most things in life, there is a downside.
Consider these scenarios before you borrow from your 401(k):
- You lose your job: If you lose your job, you must pay
back the money almost immediately -- say, within 60 days.
Worse, it may be impossible to qualify for a loan with
a bank to pay off your 401(k) loan if you are out of work.
- Default: If you default on the loan, the IRS will consider
this a withdrawal, and you will be subject to taxes on
the money you withdrew. Chances are if you have defaulted
on the loan, you do not have the extra cash to pay the
- Paying Taxes Twice: When you pay back your loan, you
are paying with after-tax dollars. In other words, these
payments are not pre-tax or tax deductible. When you withdraw
this money for retirement, it will be taxed again as ordinary
income. Maybe the low interest rate you got is not that
great when you consider the tax consequences.
- Derailing the Retirement Train: You have now subtracted
from your retirement plan, and that money will no longer
be working for you. As we discussed in the first lesson,
time is one of your most powerful allies in retirement
saving. In addition, the time it takes to pay back your
loan is time during which you do not get compounded returns.
I have a friend who worked with me at IBM. He borrowed against
his 401(k) to send his four kids through college. When IBM
started laying off scores of employees, my friend had many
sleepless nights worrying about how he could cover those
loans if he lost his job. Luckily, he kept his job. On the
downside, however, he is over 70 now and still working. Because
he borrowed against it so often, his 401(k) account did not
build up to a point that would have secured a timely and
comfortable retirement. When you borrow against your 401(k),
you are eroding your ability to retire comfortably.
For more information on loans, see A Commonsense Guide to
Your 401(k), Step 28.
Leaving Your Job
Who says you can't take it with you? Unlike the traditional
company pension plan, 401(k) plans were designed to be portable.
Moreover, unlike pension plans, any money you contribute
vests immediately: it is yours. Before you take the money
and run, there are certain things you should know about timing
the extraction of your 401(k) account.
If you change companies, you can take out the money from
your 401(k). However, if you do not want to pay taxes and
want to avoid the potential 10 percent early withdrawal penalty,
you must put the money in another tax-sheltered account.
One option is to roll it over into your new employer's 401(k)
plan, if the company allows it. Another option is to move
it into an IRA.
There are two ways to move your 401(k) funds tax free:
- A regular rollover
- A direct rollover
A Regular Rollover
With a regular rollover, you get a check, minus 20 percent
withholding for taxes. You must deposit this check into your
new tax-sheltered account within 60 days. You can only get
back the money you lost in the withholding tax by filing
your taxes. To make the whole rollover tax-free, you have
to cough up the extra 20 percent using your own money, until
the government reimburses you. If you do not have the extra
cash for the 20 percent, and can only deposit the 80 percent,
the government will tax you on the 20 percent, plus you might
end up having to pay a 10 percent early withdrawal penalty.
A Direct Rollover
With a direct rollover, the trustee of your 401(k) plan
directly deposits your funds into your tax-sheltered account.
No fuss, no muss – no 20 percent withholding, no 60
days to sweat.
The good news is you do not have to decide the minute you
leave. Most employers allow you to keep your account open
for some time after you leave. Spend the time to find out
what your rollover options are; your money will remain safe
until you do.
you have looked at you rollover options, you may decide that
the best option is to leave your 401(k) account right where
it is. Maybe the investment options are better. Of course,
you may no longer contribute or receive matching funds on
this account. For that you will have to participate in your
new employer's 401(k).
You can also take the money in a lump sum. However, there
will be a 20 percent withholding tax deducted from it; you
will have to pay taxes on it; and if you are not yet 55 when
you leave, you will also be paying the 10 percent early withdrawal
A Little at a Time
If you are dead-set on getting your hands on some of that
cash, you do have the option of taking periodic withdrawals
based on your life expectancy. You will still have to pay
taxes on it. No matter what age you are, this option excuses
you from the early withdrawal penalty. Once you start down
this path, you have to keep it up for five years, or until
you are 59 1/2 -- whichever is later.
Timing Your Exit
If you are contemplating leaving your job, you should know
two things. While all your contributions vest immediately
and are yours to keep, some companies have different vesting
requirements for the employer match of your contributions.
The money your employer contributed, in other words, may
or may not be yours to keep. You need to know if your company
has different vesting requirements for employer contributions.
Wouldn't you hate to leave a job after four years and 11
months, only to find out that your employer matching funds
only vest after five years? You can find such information
in your SPD.
In addition, your company may not make its matching contributions
on the same schedule as your contributions. For instance,
you may contribute to your 401(k) on a bi-monthly basis,
but your company may match the funds you contribute on a
quarterly basis. You might want to wait until the end of
the quarter to get the employer matching funds before you
leave the company.
For more information about how leaving your job can affect
your 401(k) contribution, see A Commonsense Guide to Your
401(k), Step 35.
It happens. The positive aspect is that no one will be stuck
with a 10 percent early withdrawal penalty.
When you first began to invest in your 401(k) plan, you
were asked to provide a beneficiary. Nevertheless, as time
goes by, you might need to make changes to the beneficiary
or beneficiaries of your 401(k) account. You may have been
single and childless when you started the plan, but that
may have changed. You would hardly want your money to go
to an old boyfriend instead of your family. Moreover, as
we will see later on, your beneficiary can affect your planned
What happens to your 401(k) after you die? If the beneficiary
is not a spouse, then the beneficiary will have to pay income
taxes on it. In addition, the value of the 401(k) will be
included in any estate valuation for estate taxes.
If you are trying to keep your beneficiary from having to pay taxes on
your 401(k), DO NOT list a Revocable Trust as the beneficiary. See
Steps 77 and 78 of A Commonsense Guide to Your 401(k) for more information.
If the beneficiary of your 401(k) is your spouse, he or
she can roll it over into his or her IRA without paying any
taxes. Otherwise, your spouse can just take the lump sum
-- the money will be taxed, but the 10 percent early withdrawal
will not apply. Again, if your spouse was born before 1936,
the 10-year forward averaging calculation applies. If your
spouse dies, disposition of his or her 401(k) account should
be one of the things you discuss with a tax accountant or
estate planning professional. Mary Rowland speaks in detail
about beneficiary designation in Step 29 of A Commonsense
Guide to Your 401(k).
Given that your 401(k) is designed to be a fund for retirement, it make
sense that it's difficult for you to get your money out of it before
you retire. In this lesson, you learned how to access your funds before
you retire, and what penalties and taxes you will have to pay as a
result. In the next lesson, you learn how to work with your hard-earned
retirement once that golden day arrives.
Quiz1: Lesson 3, Quiz 1
Answer the following questions about this lesson
1. True or False: You cannot withdraw money from your 401(k)
until you retire.
2. Which of the following are included in the government's
definition of a hardship withdrawal? (Check all that apply)
A. College tuition and expenses for the coming year
B. A down payment on a secondary residence
C. Unreimbursed medical expenses for you, your spouse, or your dependents
D. The need to avert an eviction from or foreclosure on your secondary
3. True or False: You can't borrow from your 401(k)
4. What kind of rollover requires that you pay 20% of your
401(k) balance in taxes (for which you can be reimbursed
when you pay your yearly income tax)?
A. A regular rollover
B. A direct rollover
5. True or False: If the beneficiary for your 401(k) is
your spouse he or she will have to pay income taxes on the
account if you die.
Quiz 1: Lesson 3, Quiz 1 answers
401(k) Basics: Laying the Groundwork for a Secure Retirement
Lesson 4: Your 401(k) at Retirement
It might seem too early to talk about what happens to your
401(k) plan when you retire (after all, we haven't discussed
investing or general retirement planning), but I think it
helps you see the big picture if you understand what you
want from your 401(k) at the outset.
Congratulations -- you're going to retire. What are you
going to do with your 401(k) plan now? And what about accessing
some of that retirement loot? The good news is that if you
are over 55, you will probably be able to stay out of the
10 percent early-withdrawal penalty box. Of course, with
withdrawals come taxes -- but only on the money you take
out. So withdrawing your 401(k) money becomes an exercise
in figuring out how to access the money you need for retirement
while paying the lowest tax rate for it.
You have a number of options at retirement.
- Withdraw your funds in one lump sum
- Leave them in your 401(k) account
- Roll the funds over
- Withdraw your money in regular sums over time
The remaining pages of the lesson look at each of these
in detail so you can find the right option, or combination
of options, for you.
Take It or Leave It
This is the all-or-nothing approach: you can withdraw all
of your funds in one lump sum or simply leave them right
where they are.
The lump sum is an appealing option, but as we saw in our
last lesson, it has some serious tax implications. While
it's tempting to get your hands on all your money at once,
you will still pay pretty high taxes -- in the range of one-third
to one-half of your lump sum -- all due in the year you take
the lump sum. And once you withdraw it, any money you make
by investing that money is now taxable. Again, there is a
partial loophole: if you were born before 1936, you can use
10-year forward averaging to lighten your tax burden.
If you have not been an active investor outside of your
401(k) plan, you may find managing and investing this amount
of money to be a daunting task. We will be covering investment
in the next lesson, but if investing the lump sum is where
you are headed, make sure you read A Commonsense Guide to
Your 401(k), Step 73.
Hate making those tough life decisions? You can leave your
money in your 401(k). There may be some real advantages to
- Your money will continue to grow, while remaining sheltered
- You are already familiar with the plan requirements
and investment options.
- If you declare bankruptcy, your 401(k) account will
be protected from your creditors. This is not typically
the case with IRA accounts. (Your 401(k) plan is also
- protected if the company sponsoring your 401(k) goes
- Withdrawals are easy.
- Some companies even offer annuity plans that have very
competitive features at very attractive costs. If you choose
to exercise this option, make sure you understand all the
features of the annuity, as well as all the associated
fees and commissions.
Before you retire, set up some time with your Human Resources
department to understand the resources your company offers
to help you after retirement. Also, talk with recent retirees
to get a sense of how your company treats them.
For more information of leaving your 401(k) with your employer,
see A Commonsense Guide to Your 401(k), Step 74. Another
good book for retirees is Margaret Malaspina's Don't Die
Broke: Taking Your Money out of Your IRA, 401(k) or Other
You learned in the last lesson that rollovers are an option
for moving your money after you leave your job. They are
also an option when you retire.
You can rollover your 401(k) money into an IRA, as described
in the previous lesson. Some advantages of this option are:
- Your money will continue to grow, remaining sheltered
- You may get a wider range of investment options than
you would have if you left the money in a 401(k).
- If you already have an IRA, your finances may be easier
to manage if you consolidate all your retirement funds
in one account.
- You can convert an IRA into a Roth IRA, which has additional
benefits (discussed below).
Some disadvantages of an IRA rollover:
- Withdrawing money from an IRA before age 59 1/2 puts
you back in the 10 percent penalty box.
- Although both IRAs and 401(k) plans involve mandatory
withdrawals at age 70 1/2, IRAs prohibit contributions
after this age. If you are working even part-time at age
70 1/2, you can still contribute to your 401(k) plan and
even postpone the start of mandatory withdrawals.
to a Roth IRA
The Roth IRA, introduced in the Taxpayer Relief Act of 1997,
offers some unique provisions that may make this an attractive
retirement vehicle. As long as your adjusted gross income
is less than $100,000, you can convert an existing IRA into
a Roth IRA.
When you convert your IRA into a Roth IRA, you must pay
taxes on the amount you convert. But the short-term tax consequences
of converting to a Roth IRA may be worth the long-term advantages.
Some of the features of a Roth IRA are:
- Once you pay the taxes at conversion, you never again
pay taxes on any withdrawals, including your investment
gains. This means that all the money made in your Roth
IRA is tax-free
- There are no mandatory withdrawal requirements. As we
will see below, the mandatory withdrawal requirements starting
at age 70 1/2 for 401(k) plans and IRAs can be tricky and
- You can continue to contribute to a Roth IRA after the
age of 70 1/2. This is not true of IRAs, and is only true
of 401(k) plans under special circumstances.
- Withdrawals from Roth IRAs are not included in taxable
income -- which may make a difference when calculating
the taxability of your Social Security income.
Show Me the Money
Of course, the whole point of a retirement account is to
fund your retirement. Withdrawals can be tricky, so it is
important to know the rules and regulations associated with
After retirement, money in both IRA and 401(k) plans is
fairly accessible. Between the ages of 59 1/2 and 70 1/2
it's all yours for the taking -- or leaving. Not so after
age 70 1/2, when you must start taking minimum withdrawals
from an IRA, and, if you are not working, from your 401(k)
plan. The government does not allow you to keep your money
tax-free forever. So there's an age when, to finally earn
some tax revenue, the government requires you to make minimum
Mandatory Minimum Withdrawals
Penalties for getting this part wrong are sizeable. You
must start making mandatory minimum withdrawals by April
1 of the year after the calendar year in which you turn 70
1/2. This rule always applies to IRAs. If you are still working
at the company where your 401(k) plan is, you can postpone
your 401(k) withdrawals. But check the IRS provisions for
this exception carefully. For instance, if you own 5 percent
or more of the company, you are not eligible to postpone
the start of mandatory minimum withdrawals.
If you do not start making withdrawals, or you mistakenly
withdraw an amount below the mandatory minimum, you must
pay 50 percent of the difference between the amount you withdrew
and the minimum requirement, as well as the tax on the withdrawal.
There are only two acceptable ways to calculate your minimum
withdrawal: the recalculation method and the term-certain
method. But both methods are based on a calculation of life
If you have not specified a beneficiary for your 401(k)
plan, then you will use the IRS single-life-expectancy table
for your life-expectancy calculation. This is a pretty straightforward
table. You look up your age, and it tells you how many years
you are expected to live.
If your beneficiary is a person and not a charitable organization,
then you will use the IRS Joint Life (or last survivor) life-expectancy
table for your life-expectancy calculation. If your spouse
is your beneficiary, you find where your ages intersect on
the chart -- this will calculate your joint life expectancy.
If your beneficiary is not your spouse, the same thing applies,
unless your beneficiary is more than 10 years younger than
you are. In that case, the age of your beneficiary is adjusted
down 10 years.
Your withdrawals vary according to these calculations.
The term-certain method is the easier of the two methods,
and tells you exactly how much to take out of your account
year-by-year based on one calculation. If your calculated
life expectancy is 22 years, then the first year you take
out 1/22 of your account balance. In the second year you
take 1/21 of your remaining account balance; in the third
year you take 1/20 of your remaining account balance, etc.
The recalculation method starts the same way. The first
year, you take out 1/22 of your account balance. But in the
second year, you would recalculate your life expectancy.
The recalculated life expectancy could be 21.3 years. For
the second year, you would take out 1/21.3 of your account
balance. Each year, you recalculate your life expectancy
and make the adjusted withdrawal amount.
There is a hybrid method that lets you combine the two methods.
For instance, you could choose recalculation and your beneficiary
could choose term-certain. A good financial adviser could
help you work through this option.
Which method should you use? Whichever is best for you.
Many people like the simplicity of term-certain. Do the calculation
once and be done with it. People who are interested in paying
the least amount of tax like the recalculation method, because
it tends to come up with a lower minimum withdrawal amount.
Recalculation also helps ensure that you won't outlive your
money. With term-certain, if you and your spouse outlive
that 22-year projection by a few years, you will have already
withdrawn all of your 401(k) funds after the 22nd year.
One drawback of the recalculation method is that, should
an older spouse die, the subsequent recalculations must be
made on the younger surviving spouse's life expectancy alone.
This may dramatically increase the minimum withdrawal amount
--depending on the spouses' age difference. If the remaining
spouse dies, the estate must pay taxes on the remaining balance.
With term-certain, when one spouse dies, the other can keep
the original withdrawal schedule. When the remaining spouse
dies, the estate can continue to receive 401(k) withdrawals
according to the original schedule, thus delaying the tax
liability on the account.
Onward to Investing
Now that you know what a 401(k) plan is, how to put money
into it, and how to get money out at any age, it is time
to learn how to maximize your investments in your plan so
you have the most money available when you retire. The next
lesson looks at how to best invest the money in your plan
to maintain a sufficient gain without losing sleep over the
level of risk you have assumed.
Quiz Lesson 4
Answer the following questions about this lesson
1. True or False: When you retire you can just leave your funds in your
2. True or False: When you retire you can roll your 401(k)
funds into an IRA.
3. True or False: As long as your adjusted gross income
is less than $150,000 you can convert an IRA into a Roth
4. True or False: After age 70 1/2 there are no minimum
withdrawals from your 401(k) plan.
5. The mandatory minimum withdrawal is based on:
A. How many years you were employed
B. How many dependants you have
C. Your life expectancy
D. How much money is in your account.
Answers Lesson 5
1. True - As long as you aren't 70 1/2 you can leave your
funds in your 401(k) when you retire.
2. True - Rolling your 401(k) into an IRA is an option when you retire.
3. False - Your adjusted gross income must be less than $100,000 to convert
an IRA into a Roth IRA.
4. False - Formulas defined by the government specify the minimum you
must withdraw from your 401(k) every year after you turn 70 1/2.
5. Your life expectancy - Life expectancy is used in all calculations
of the mandatory minimum withdrawal.
401(k) Basics: Laying the Groundwork for a Secure Retirement
Back to lesson
Lesson 5: Investing and Your 401(k)
If you have completed Lesson 4's assignment, you have already
taken your risk tests (found in A Commonsense Guide to Your
401(k), Steps 38 and 39) and have some understanding of your
personal risk tolerance and risk capacity, and how they will
affect your investment strategy. Before we get into how to
invest your 401(k) assets, let's spend a little time looking
at the risks associated with investments and examining some
of the tools and terminology the investment pros use.
Some investments are more sensitive or vulnerable to fluctuation
than others are. If you understand how different kinds of
investments behave under variable circumstances, you will
be able to choose investments that best match your needs.
Let's examine some of the basic risks.
Inflation: The Continual Increase of Prices of Goods
Inflation is a real threat for investors. If you invest
your money in a portfolio that only returns 3 percent (like
the one shown in Figure 5-1), but inflation is averaging
4 percent, at the end of your investment period your money
will actually buy fewer goods and services than when you
Fig. 5-1: Short and long term risk
Inflation will erode your investment. Even though you end
up with more money than when you started, inflation has reduced
your money's buying power. What is the solution?
Make sure you find investments that either keep pace with or outpace
Interest Rates: Some Investments Are Very Sensitive
to Changing Rates
Of all your investment options, bonds are the most sensitive
to interest rate changes. Bonds go up when interest rates
go down, and they go down when interest rates rise. Why?
If I have a bond that pays 5 percent interest, and interest
rates rise to 7 percent, other people will be able to get
new bonds at 7 percent interest. My old bond will not be
as valuable; if I want to sell it, I will have to let it
go for a reduced price. The longer the term or the maturity
of the bond, the more sensitive it is to changes in interest
Other investments are also sensitive to interest rates.
Financial stocks such as banks and mortgage companies have
historically done poorly in times of rising interest rates.
Why? They tend to hold many fixed-interest-rate investments,
like mortgages, which suffer just like bonds.
My advice to you is do not buy and hold long-term bonds. Although bonds
are an important part of a diversified portfolio, as shown in Figure
5-2, investors should stick with short and intermediate terms (fewer
than 10 years).
Fig. 5-2: Low risk in both short
and long term
Credit Risk: Default by a Borrower or Issuer of
When you buy a bond, you are lending money to the issuer.
This entails a credit risk -- in other words, a risk that
the bond issuer will not be able to pay on the loan, or will
default on the bond. The greater the credit risk, the higher
the interest rate the bond pays. "Junk bonds" (high-yield
bonds) pay better interest rates, but carry higher credit
Check the quality of the bonds you buy or that your bond mutual funds
buy. Investment-grade corporate bonds (rated AAA, AA, A, or BBB) or
government-issued bonds have a lower credit risk.
Nondiversified Risk: Too Many Investment That Are
Concentrating your investments around only a few kinds of
assets is risky: if one does poorly, they will all do poorly.
This is particularly apparent in the high-tech sector, where
stocks can fly sky-high, then suddenly take a collective
swan dive that leaves investors and the news media gasping.
Other sectors behave the same way. Do you like the energy
sector? If that's all you own and oil prices go lower, you
are out of luck. Are drug stocks doing well? If you load
up and Congress changes Medicare regulations, it could take
the whole sector down -- and you with it.
Diversify! The more variety you have in your investments, the less susceptible
you will be to a change or event in one sector or asset type.
For additional investment risks see A Commonsense Guide
to Your 401(k), Step 40.
Some Examples of Low- to Medium- Risk Portfolios
In our discussions on this page, you have seen illustrations
of a portfolio that has both long-term and short-term risk
as well as one that has a low risk in both the long and short
term. Both have an average return of less than 4 percent.
This just shows that you can have a lot of risk with little
return or low risk with little return. There has to be a
better way, and there is. The following three illustrations
improve the return offered by the portfolio while maintaining
a medium risk in the short term and a low risk in the long
Fig. 5-3: Medium risk in short
term and low risk in the long term
Fig. 5-4: Medium risk in short
term and low risk in long term
Fig. 5-5: Medium risk in short
term and low risk in long term
Terms and Tools of the Pros
To get a better handle on evaluating investment options,
let's look at what the pros consider when they examine investment
options. Following are a few terms and tools that may be
helpful for you.
We talked a little about diversification. Clearly, the best
strategy is to own investments that behave differently over
time and in the face of certain events. But how do the pros
Pros use correlation to measure how two securities -- or
two mutual funds – perform relative to one another.
Here is how it works: If two investments behave exactly the
same way, they have a perfect positive correlation, and a
correlation coefficient of +1.0. If two investments behave
exactly opposite to one another, they would have a perfect
negative correlation of -1.0. All correlation coefficients
range between -1.0 and +1.0.
If you were going to buy two different investments and wanted
them to offer you diversification, you probably would not
want them to have a correlation coefficient much above +0.75.
If your investments are too similar, there is no real advantage
to the hassle and expense of owning both of them. That is
why you probably would not want to own more than one large
company stock mutual fund. Chances are, adding another large
company stock mutual fund would not add much to your diversification;
large company stock funds tend to have high correlation coefficients
with one another. Therefore, if you already own a large company
stock fund, you might consider adding a small company stock
fund, a short-term bond fund, or even an international stock
Diversification -- the strategy you should be aiming for
-- results from making sure investment assets do not strongly
correlate with one another.
For more information about correlation, see A Commonsense
Guide to Your 401(k), Step 41.
Beta and Alpha -- It's All Greek to Me
There are also a number of academic tools that investors
use to measure the risk of investments.
Standard deviation is a measure of an investment's volatility;
it measures how much an investment deviates from its average
return. For instance, I might have two investments that have
gone up, on average, the same amount over the past five years.
However, one stock may have a smaller standard deviation
than the other stock.
This means that the stock with the smaller standard deviation had a steadier,
more predictable increase. Although the second stock had the same average
return, it had more ups and downs along the way. If I want to invest
in one of these stocks, I am going to choose the one with the lower standard
deviation. A lower standard deviation indicates I will have a lower risk
investment for the same expected return.
Beta is an indicator of how volatile an investment is, compared
with the overall market. If an investment has a beta of 1.0,
when the overall market goes up, it goes up by the same amount.
If the market goes down, it goes down by the same amount.
If an investment has a beta of 1.25, when the overall market
goes up, it goes up 25 percent higher than the market. However,
when the market goes down, it goes down 25 percent lower
than the market.
In portfolio terms, alpha represents how well a manager
performed, based on the risk of his portfolio. Positive alphas
indicate better returns than one would expect; negative alphas
indicate that the portfolio did not perform as well as one
R-squared is a close relative of correlation. It scores
how well your investment tracks the market it's compared
to (usually the S&P 500 Index) and allows you to judge
how meaningful your beta and alpha measures are. If your
investment does not really behave like the market overall,
then using beta and alpha measures -- which compare it to
the behavior of the market -- are not that useful. An r-square
of 100 indicates that your investment moves in perfect tandem
with the market. An r-square of zero indicates that there
is no relationship between the behavior of your investment
and the behavior of the overall market. In other words, unless
an r-square is high, do not put too much faith in the alpha
and beta measures.
For more information on risk measurements, see A Commonsense
Guide to Your 401(k), Step 42.
Asset allocation allows you to combine risky assets, like
small company or emerging-market stocks, with investments
with lower, or different, risk profiles. This will result
in less volatility and fewer sleepless nights. You can tailor
your asset allocation to include more or less risky investments,
depending on your risk tolerance and risk capacity.
Anyone with a long investment horizon should consider putting
the majority of his or her investments in stocks or stock
funds. Over the long run, stocks return more than bonds --
but then they are riskier and more volatile. Adding bonds
to your portfolio will help smooth out the bumps. A portfolio,
like the one shown in Figure 5-6, of 60 percent stocks and
40 percent bonds is typical. If you have a long time to invest
before you need to access your money, you might consider
a higher percentage of stocks or stock mutual funds. If retirement
is just around the corner, you may want to invest conservatively
in a heavier concentration of bonds than stocks.
Fig. 5-6: Medium risk in both
long and short term
Stock Styles: Growth, Value, and Index Funds
Stocks and mutual funds come in all shapes and sizes. Many
mutual funds are tailored to different investment preferences
Some investors prefer "value" stocks. Investors
typically invest in a value stock because they believe the
stock is undervalued compared to others like it.
A P/E ratio (price-to-earnings ratio) helps indicate whether
a stock is undervalued. The P/E ratio is a stock's price
divided by the amount that the issuing company earned on
an annual per-share basis. Sometimes this ratio is called
a company's multiple. Stocks in the same sector should have
similar P/E ratios, or multiples.
Value investors use this ratio to determine whether a company
is trading below the industry average multiple. Value funds
gamble on the belief that undervalued stocks will turn around
when the market finally values the company at its true worth.
Some investors prefer growth stocks. Growth stocks tend
to have high P/E ratios, but also have double-digit sales
and earnings growth rates. Many companies with fast earnings
growth rates have fast stock price growth rates, too. Growth
investors want to go along for the ride. Buying growth stocks
tends to be a little riskier than value investing, as Figure
5-7 shows, but it often brings larger returns.
Fig. 5-7: High risk in short
term and medium risk in long term
Many investors think trying to pick the right growth or
value stocks is all a lot of commotion. No one can really
predict what an individual stock is going to do. So why bother?
However, most index funds -- funds based on one of the market
indices like the S&P index or NASDAQ index -- do as well,
if not better, than the average fund. There are other advantages
to index funds. Because the stocks are automatically selected
(the same as those in the index), the fund and fund owners
do not have to pay fees to an active (non index) fund manager
-- so index funds have very low fees and expenses. In addition,
because the stocks in the index tend to stay constant, there
is not a lot of trading that occurs within an index fund.
This keeps expenses low.
Bond Styles: Length and Credit Risk
We already learned that the longer the term of a bond, the
more interest-rate-sensitive it is -- which explains why
bond funds differentiate themselves as short term, intermediate,
or long term. Short-term bond funds carry the least interest-rate
risk, but they also pay lower interest rates.
Some bond funds identify themselves according to the credit
risk they carry. High-yield bond funds offer better yields
because they invest in bonds that carry high credit risk
-- in other words, noninvestment-grade bonds. There are government
bond funds that carry almost zero credit risk. The taxing
authority of the government backs the bonds in these funds.
Government bonds pay lower interest rates.
For an example of asset allocations, see A Commonsense Guide
to Your 401(k), Part 8. Mary Rowland asked a top-notch financial
planner, Harold Evensky of Coral Gables, Florida, to come
up with 14 different asset allocations according to risk
Your 401(k) Investments
The good news is that you do not have to evaluate every
investment option under the sun to effectively invest your
401(k) money. Most companies have a small number of investment
options from which to choose. This sometimes is the bad news,
too. In reality, a 401(k) plan only has to offer three investment
options with different risk profiles. However, many companies
offer the full range of funds available within a specific
fund family, which can easily total fifty or more options.
Here are a few things you should keep in mind when you put
together your 401(k) investment choices. As a note, if you
find yourself wondering if all of this work is worth the
trouble, take a look at Figure 5-8 for a reminder of how
investing in your 401(k) can benefit you.
Fig. 5-8: How investing in your
401(k) can benefit you
Check Out the Fund Prospectus and/or Performance
Not every company provides you with a prospectus for each
investment option. Some do, so ask. Prospectuses make dull
reading, but they do cover things like fees and expenses
(i.e., load or no load). Some of your choices may be cheaper
than others, but offer the same or better results. The prospectus
will also cover a fund's performance history and investment
philosophy. If you can't find a prospectus from the company,
your investment options may be made through one of the big
fund companies like T. Rowe Price, Janus, Vanguard, etc.
If you are researching a publicly traded mutual fund, you
can get a prospectus from the mutual fund company -- many
are available online.
There are also companies that rate different mutual funds
and provide information about the stocks they own, their
investment philosophy (i.e., value, growth, large company,
small company, etc.) and their performance compared to other
similar funds. For instance, even if you wanted a small company
growth fund, your only choice through your company may be
a real dog. Do not invest in dogs no matter what your asset
allocation says you should do. You can find this rating information
on the Web or at your public library.
Don't Time the Market -- Use Dollar Cost Averaging
Not even experts can pick the exact moment to buy. If you
are in it for the long haul, you should invest your money
every pay period. Sometimes prices are higher, sometimes
prices are lower. You should invest the same amount at regular
intervals. This way you will buy a few shares at high prices
and many shares at lower prices -- this is called dollar
cost averaging and allows you to spread your risk over time.
Studies have shown that people who invest this way end up
paying less money per share than those who buy shares in
one lump sum. In addition, if you try to wait for the market
to go lower before you buy, you might miss out as it keeps
Is Your Company's Stock Offered? Pass
Many companies offer their own stock. No matter how good
your company stock is, I would pass. How many eggs are you
going to put in this basket? You already work there, after
all. What if the company tanks? Think Enron. You could lose
your job and a piece of your 401(k) to boot. If your company
has a good stock, one of the mutual funds you can select
from probably owns it. Do not buy more.
Rebalance, but Don't Fiddle
After you decide on your asset allocation and make investment
choices that are consistent with that allocation, leave your
fund alone. Let it do its work. There are exceptions, however.
Once a year -- twice if you are obsessive -- check on the
asset balance. One of your high fliers may have grown a lot,
and what was supposed to be only 20 percent of your portfolio
is now 40 percent. Congratulations. While it is tempting
to "let it ride," you may want to readjust the
investment down to keep your portfolio balanced. You can
do this in two ways: either by selling off some of the investment
or by lowering the percentage of investment capital you dedicate
to that fund in the future.
For more investment tips, see A Commonsense Guide to Your
401(k), Steps 51-58.
At the Extreme
All of the example portfolios you have seen in this lesson
have had a low or moderate degree of risk associated with
them. If you are brave-of-heart, or just curious, the following
six portfolios illustrate extreme investing strategies that
have high risk in both the short and long term. As always,
think carefully about your own needs and risk-tolerance before
you set up your portfolio, and consider consulting a financial
advisor before you travel the extreme investing road. This
is your retirement fund, after all.
Fig. 5-9: Extreme investing
-- high risk in both short and long term
Fig. 5-10: Extreme investing -- high risk in both short and long term
Fig. 5-11: Extreme investing
-- high risk in both short and long term
Fig. 5-12: Extreme investing
-- high risk in both short and long term
Fig. 5-13: Extreme investing
-- high risk in both short and long term
Fig. 5-14: Extreme investing
-- high risk in both short and long term
In this lesson, you learned the basics of balancing risks
with returns and looked at a variety of portfolios with different
combinations of both. In the final lesson of the course,
you learn about what you need to do now to begin planning
for your retirement. It is difficult to invest properly to
meet a retirement goal if you are not sure what that goal
True or False: If the return on an investment is less than
inflation you will lose money over time.
A. True - Inflation is a real threat for investors. If
you invest your money in a portfolio that only returns 3
percent, but inflation is averaging 4 percent, at the end
of your investment period your money will actually buy fewer
goods and services than when you started.
True or False: The shorter the term or maturity of a bond the more sensitive
it is to changes in interest rates.
B. False - The longer the term or the maturity of the bond, the more
sensitive it is to changes in interest rates.
True or False: The lower the credit risk the lower the interest rate
a bond pays.
A. True - The greater the credit risk, the higher the interest rate the
True or False: Concentrating your investments around only a few kinds
of assets is risky: if one does poorly, they will all do poorly.
A. True - The more variety you have in your investments, the less susceptible
you will be to a change or event in one sector or asset type.
Two stocks or funds that have perfect correlation have a correlation
B. 1.0 - If two investments behave exactly the same way, they have a
perfect positive correlation, and a correlation coefficient of +1.0.
Which of the following are tools investment professionals use to measure
the risk of an investment? (Check all that apply.)
A. Beta - Beta is an indicator of how volatile an investment is, compared
with the overall market.
B. Alpha - Alpha represents how well a manager performed, based on the
risk of his portfolio
D. r-squared - R-squared scores how well your investment tracks the market
it's compared to (usually the S&P 500 Index) and allows you to judge
how meaningful your beta and alpha measures are.
True or False: Investors invest in growth stocks because they believe
the stock is undervalued.
B. False - Investors typically invest in a value stock because they believe
the stock is undervalued compared to others like it.
True or False: You should invest in your company's stock as part of a
complete retirement portfolio.
B. False - If your company has a good stock, one of the mutual funds
you can select from probably owns it. Do not buy more.
True or False: You should rebalance your 401(k) investments monthly.
B. False - After you decide on your asset allocation and make investment
choices that are consistent with that allocation, leave your fund alone.
Let it do its work.
401(k) Basics: Laying the Groundwork for a Secure Retirement
Lesson 6: Getting a Handle on Retirement Planning
Retirement Planning -- Now
Planning for your retirement should not become a lifelong
obsession, but it deserves at least as much time as you would
spend contemplating buying a house or a car.
How Much Will You Need? How Much Can You Save?
Most experts say that you will need about 70 percent to
75 percent of your annual salary to live on in retirement.
There are a number of retirement worksheets available online
that can help you develop the numbers, but in Step 4 of A
Commonsense Guide to Your 401(k) Plan, Mary Rowland gives
an example of a person earning $75,000 needing approximately
$750,000 at retirement. I know this looks like a huge number,
but it is not as hard to do as you might think.
Remember that in our first lesson, Kyle was able to save over $1,000,000
with his 401(k) -- and he was only contributing $3,000 a year.
Bloomberg.com has a retirement calculator that can help
you figure out how much to contribute to your 401(k). You
can play around with the contribution amounts, years to retirement,
and investment rate of return until you get to where you
need to be. This tool is especially helpful for answering
questions such as, "Can I retire at age 45?" and "How
aggressively should I invest my 401(k) plan?"
Your 401(k) may not be the only retirement resource you
have. Maybe you or your spouse has a pension. Do you already
have an IRA or a Roth IRA? Are you thinking about selling
that six-bedroom house and moving into something smaller
and cheaper when you retire? Don't forget about the other
resources when you plan your retirement.
By this time, we all know that Social Security is a pretty
iffy proposition. Don't bank on Social Security -- but do
make sure your records are accurate and up to date just in
case. To get your Social Security records call 1-800-772-1213
for your SSA-7004 form.
The "B" Word
Have you ever built a budget before? It's an eye-opening
experience. In most weight-loss programs, professionals recommend
that you write down everything you eat. Most people have
no idea how much they indulge until they write it down. The
same thing happens with expenses. People grossly underestimate
how much they spend each year. Unfortunately, many people
also go into retirement underestimating what they will spend.
Put together two budgets: a budget for what you spend now
and a budget for what you will spend during retirement.
Use the financial statement in A Commonsense Guide to Your
401(k), Step 65 as a guide.
Retirement Planning -- Getting Closer
It's getting to be that time. What should you do to prepare?
Pay Off Debt
Why are you carrying credit card debt that you pay 16 percent
interest on, while your 401(k) money is aggressively invested
and only making 10 percent? You are not alone. Credit card
debt in the United States is at staggering levels. But you
should not carry this debt into retirement. Writing down
what you owe – on all your cards -- is just as enlightening
as writing down what you spend.
Make a list of how much you owe, the interest rate, and
the minimum due for every card. Pay the minimums on all the
lower-interest-rate cards while you completely pay off the
higher-interest cards. Be aggressive, even if it hurts. Take
it out of savings. Transfer your balances to cards with lower
interest rates. Do whatever it takes, but pay it all off
before you retire. Tear up your high-interest cards. Then
pay off the little guys. Mary Rowland offers several tips
for paying off debt in Step 60 of A Commonsense Guide to
Pay Down Your Mortgage
If a fair chunk of your mortgage payment is still paying
off interest, you should consider prepaying on your principal.
By making extra payments on your principal, you can take
years off your mortgage and save yourself from making all
those additional interest payments. This is a financially
savvy thing to do, in addition to giving you the emotional
freedom of not having to carry your mortgage into retirement.
And while paying off the mortgage really doesn't make much
financial difference if you're down to mostly principal,
plenty of people pay off their mortgage right before retirement
anyway. It makes them less anxious about retiring. For more
information, see A Commonsense Guide to Your 401(k), Step
It's especially important to have all your records and paperwork
organized going into retirement. Keep track of your birth
certificates (you'll need these to apply for Social Security),
bank accounts, annual 401(k) and IRA statements, investment
records, business records if you are self-employed, mortgage
statements, insurance policies, income tax returns, and more.
Review Your Portfolio
It used to be that retirees were advised to get out of those
risky stocks and park their portfolio solidly into bonds.
But most financial planners recommend that today's retirees
continue to invest in stocks. One reason is that retirees
are living longer. If you're retiring at 65, some of your
retirement money may be invested for another 20 years. That's
a pretty long-term horizon. However, there is still room
for adjustment. While you still want to be invested in stocks,
you may consider adjusting your asset allocation to a lower
percentage of stocks or think about shifting your more aggressive
stock funds into some that are a little more conservative.
Mary Rowland offers additional information on asset allocation
and conservative stock ideas in Steps 66 and 67 of A Commonsense
Guide to Your 401(k).
In Assignment #4, you evaluated your risk tolerance and
risk capacity. But over time, your feelings about risk may
change. Before you retire, perform a risk checkup.
Delay Collecting Social Security
People born before 1936 or earlier get full Social Security
benefits at age 65. For those of you born after that, the
age requirement for full benefits gradually increases. You
can elect to receive partial Social Security benefits earlier
than the age specified by the government -- but it's not
a good idea and carries a stiff penalty. You will receive
a permanent 20 percent reduction in your monthly benefit.
With life expectancies what they are, this is not a good
Also, if you delay receiving your benefits until after you are fully
qualified, you actually get credits, or bonuses, for the delay. The increase
you get depends on how long you wait before starting to collect, and
may be larger if you have continued to earn at or above your past average
For more information on delaying your Social Security see
A Commonsense Guide to Your 401(k), Step 69.
Health Care and Long-Term Care Insurance
There was a time when companies paid full health care costs
for retirees. But chances are that either your company won't,
or you haven't been with your company long enough to receive
this benefit. Check with your company's human resources department
to understand what health benefits or options they offer
for retirees. Some companies have plans whereby a retiree
may be asked to make higher contributions to continue coverage
or may be covered under higher deductibles.
At a minimum, your company must offer you 18 months of health
insurance coverage for cost (plus a 2 percent fee). You may
be a little surprised at how expensive this coverage, called
COBRA, turns out to be. But it still may be cheaper than
other options, especially if you are currently being treated
for a pre-existing condition that may not receive coverage
under a new insurance provider.
Many companies and insurance providers offer long-term care insurance.
Initially, these plans offered very limited coverage and weren't really
worth the bother. That's changed over time. Like all insurance, long-term
care plans are a great buy when you are younger and healthier, and harder
to get or afford once you know you need them. So decide what you're going
to do early.
For more information on health insurance, see A Commonsense
Guide to Your 401(k), Steps 71 and 72.
You may save like a squirrel and invest like a wizard, but
seeking professional help may be a wise choice. Tax laws
change every year. So do the financial tools that might minimize
your tax exposure. Estate and financial planners know all
the nooks and crannies of these complicated rules and regulations.
If you have an estate worth more than $675,000, including
your house, you should seek estate-planning help. Estate
taxes currently range from 37 percent to 55 percent, but
are expected to be reduced by Congress during the Bush Administration.
An estate planner only has to have one good idea to save
you and your heirs a bundle.
If you have more money for retirement than you think you'll
ever need and want to make sure some of it ends up with your
children or grandchildren, then you should also consider
getting professional advice.
Moving? Check It Out
Thinking about moving once you retire? Potential retirees
have a very romantic notion about running away to the beach
somewhere. But if you're thinking of moving, you need to
consider this with your head, not just your heart.
You need to check out the tax laws of the state you may
be moving to. States have very different, and sometimes very
strange, tax laws. Some examples:
In Louisiana, residents who take their pension money as
a lump sum pay no state tax. However, if you take your pension
in regular payments over your lifetime, you'll be paying
six percent in state taxes. If you take your pension as a
lump sum, but roll it into an IRA, it will all become taxable
at the state level.
New Yorkers can take $20,000 a year in retirement income from pensions
and other sources free of state taxes; anything over that amount is taxed.
Pension money in a lump sum or rolled into an IRA is taxable in New York.
However, pension money distributed as an annuity is free of state taxes.
Pennsylvania is one of the few states that require residents to pay state
taxes on the money going into 401(k) or IRA plans. However, it does not
levy state taxes on the money that comes out of IRAs or 401(k)s.
Mary Rowland's book offers some good references and resources.
Her book also covers much more than we were able to cover
in just six short lessons. Those of you who have 403(b) or
457 plans will be especially glad to see a section for you.
A 401(k) plan is the most powerful tool you have to get
the retirement you deserve. The only way to miss out is by
not participating. Do it. It's easy. You'll be surprised
at how fast it grows and proud of yourself for making the
Quiz1: Lesson 6, Quiz 1
Check your answers against the correct answers in bold below.
Feel free to discuss the answers with your instructor and
fellow classmates on the Message Board.
What percentage of your current salary do most experts say
you'll need to live on during retirement?
A. 60 percent to 65 percent
B. 70 percent to 75 percent - Most experts say that you will need about
70 percent to 75 percent of your annual salary to live on in retirement.
C. 80 percent to 85 percent
D. 90 percent to 95 percent
Correct! You chose B.
As you get closer to retirement which of the following should
you do? (Check all that apply.)
A. Pay off debt - Do whatever it takes, but pay it all off before you
B. Pay down your mortgage - If a fair chunk of your mortgage payment
is still paying off interest, you should consider prepaying on your principal.
C. Get organized - It's especially important to have all your records
and paperwork organized going into retirement.
D. Start collecting Social Security
Correct! You chose A. B. C.
A company must offer you health insurance benefits for how
long after you retire?
A. 12 months
B. 18 months - By law companies must offer COBRA coverage to an employee
for 18 months after the employee retires or leaves the company.
C. 24 months
D. 36 months
Correct! You chose B.
True or False: You should divest your portfolio of stocks
once you retire.
B. False - Most financial planners recommend that today's retirees continue
to invest in stocks.
Correct! You chose B.
True or False: A good way to understand your spending habits
and create a budget is to write down everything you spend.
A. True - People grossly underestimate how much they spend each year.
A journal of spending can help you see how much you really spend and
what you spend it on.
Correct! You chose A.