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401(k) BASICS: Laying the Groundwork for a Secure Retirement

401(k) Basics: Laying the Groundwork for a Secure Retirement | Planning for Retirement

Lesson 1: What's So Special About 401(k) Plans?

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 an investor

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 are:

Pre-tax contributions
Tax deferral
Employer match
Investment options

Let's look at each in more detail.

Pre-tax contributions

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 Deferral

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.

Employer Match

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 money.

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 funds.

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.

Investment options

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 retirement.

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 Results!

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) plan.

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 investing options?

  1. Employers often match employee contributions
  2. The contributions are made pre-tax
  3. You can postpone paying taxes on the dividends your 401(k) account earns until you withdraw the money
  4. You do not have any investment options.

True or False: 401(k) programs are company-sponsored while IRAs are setup and managed by individuals.

  1. True
  2. False

If you are under the age of 50 what is the maximum amount you can contribute to an IRA in any year?

  1. $2,000
  2. $3,500
  3. $3,000
  4. $4,000

True or False: To benefit from compounding you need to let your money ride for as long as possible.

  1. True
  2. False

True or False: You get greater benefits from compounding if you use a traditional investment plan instead of a 401(k) or IRA.

  1. True
  2. False

Quiz1: Lesson 1, Quiz 1 Answers

1. A. B. C.
2. True
3. C -$3,000
4. True
5. False

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.

Age Requirement

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

  1. The Summary Plan Description (SPD), which details the following:
    1. Eligibility requirements
    2. Investment options
    3. Employer contribution limits
    4. Employer match information
    5. Plan options, such as loan provisions
  2. 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.

Contribution Limits

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.
The Government

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 to give.

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.

Your Employer

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.

After-Tax Contributions

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 for you.

You should consider some things before heading down this road:

  • 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 1/2.
  • 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 fully tax-deductible.
  • 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.

Non-Deductible Contributions

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 contributions.

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:

  1. Take the higher amount in the range provided (i.e., $44,000 if you are single) and subtract your AGI.
  2. 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 your SPD.

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.

Moving On

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:

  1. Your company's 401(k) eligibility rules
  2. Your company's 401(k) contributions limits
  3. 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?

  1. Base salary
  2. Age
  3. Amount of time employed
  4. 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 401(k) plan.

  1. True
  2. False

True or False: Your employer's 401(k) eligibility requirements must match those of the government.

  1. True
  2. False

A company's Summary Plan Description (SPD) will include information on: (Check all that apply.)

  1. Your investment options
  2. Contribution limits
  3. Eligibility requirements
  4. 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) per year?

  1. $9,000
  2. $10,000
  3. $11,000
  4. $12,000

True or False: Once you reach your yearly pre-tax contribution limit, you can not contribute any more money to your 401(k).

  1. True
  2. False

True or False: After you set up your initial 401(k) contribution amount you can't change it.

  1. True
  2. False

Quiz2: Lesson 1, Quiz 1 Answers

  1. B, C.
  2. True
  3. False
  4. A,B,C
  5. C, $11,000
  6. False
  7. False

401(k) Basics: Laying the Groundwork for a Secure Retirement

Lesson 3: Getting Money Out of Your 401(k) Before Retirement

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 need them.

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.

Hardship Withdrawals

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 your dependents
  • 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, and more.

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 34.


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.

The 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 taxes.
  • 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.

Real-Life Lesson

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.

Rolling Over

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.

Leaving It

Once 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).

Lumping It

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 penalty.

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 withdrawals later.

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).

Moving On
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.
A. True
B. False

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 residence

3. True or False: You can't borrow from your 401(k)
A. True
B. False

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.
A. True
B. False

Quiz 1: Lesson 3, Quiz 1 answers

1. False
2. A,C
3. False
4. A
5. False

401(k) Basics: Laying the Groundwork for a Secure Retirement

Lesson 4: Your 401(k) at Retirement

It's Time

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.

Lump Sum

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.

Do Nothing

Hate making those tough life decisions? You can leave your money in your 401(k). There may be some real advantages to this:

  • Your money will continue to grow, while remaining sheltered from taxes.
  • 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 bankrupt.)
  • 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 Savings Plan.


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.

IRA Rollover

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 from taxes.
  • 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.

Converting 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 restricting.
  • 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 them.


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 withdrawals.

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.

Life Expectancy

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 expectancy.

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.

Term-Certain Method

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.

Recalculation Method

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?

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 401(k)?
A. True
B. False

2. True or False: When you retire you can roll your 401(k) funds into an IRA.
A. True
B. False

3. True or False: As long as your adjusted gross income is less than $150,000 you can convert an IRA into a Roth IRA.
A. True
B. False

4. True or False: After age 70 1/2 there are no minimum withdrawals from your 401(k) plan.
A. True
B. False

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)

Investment Basics

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.

Investment Risks

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 and Services

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 started.

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 inflation.

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 rates.

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 Bonds

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 risk.

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 Alike

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 term.

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 measure this?

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 fund.

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

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 would expect.


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

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 and styles.


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 and return.

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.

Investment Checklist

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 rising.

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

Moving On

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 really is.

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 bond pays.
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 coefficient of:
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.

Retirement Calculator 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?"

Beyond 401(k)

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 Your 401(k).

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 61.

Get Organized

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 financial trade-off.
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 wage.

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.

Estate Planning

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.

Final Words

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 commitment.

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 retire.
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.
A. True
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.
B. False
Correct! You chose A.

Dr. Jerry Basford - The University of Utah
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