Today, most employers have ditched pensions in favor of "defined contribution plans" aka 401Ks or, in the case of public/nonprofit sector employees, 403Bs. That makes us responsible for instructing our employers to deduct sums from our paychecks for our retirement and largely puts the headache of how to invest those monies into our laps. That responsibility carries with it peril if we mismanage those investments, or opportunity if handled wisely.
While each 401K plan has its own set of investment choices, review of countless plans reveals recurring opportunities and pitfalls. While there's no substitute for a careful review of the details of your plan, here are twelve pieces of advice likely to be helpful:
1. Fill It Up ASAP
Needless to say, you can't profit from your 401K unless you contribute to it. Many companies match contributions. If so, that's an immediate 100% return on the amount you contribute! You're further incentivized since it may cost you as little as 60 cents of current cash flow for each dollar invested because contributions are typically tax deductible.
What's more, all earnings are tax sheltered, so it behooves you to accelerate contributions. Indeed, if your employer will let you, have your entire paycheck contributed in the first few months of each year until you hit the maximum amount the tax law allows you to sock away - generally in the 20% of salary area. In 2012, the dollar cap is $17,000 for most employees and $22,500 for those aged 50 and older.
Actually, it's not the nuances of the tax law that make the 401K so valuable. The more important aspect is that it serves as a virtual piggy bank. Whatever you can get into the 401K is unlikely to come out for that whimsical purchase, and is also shielded from creditors. The 401K is a great tool to enhance financial discipline.
2. Roll It Out and Consolidate
Many 401Ks are owned by ex-employees and were "left behind" when the employee cleaned out his desk to leave the job. If that's you, transfer it to an IRA without delay. It's typically costless and tax free.
In an IRA you're not limited to a 401K's restricted list of investment options. Even better, you're not limited to funds, so you can sidestep the fees, the opaqueness, and the duplication that fund investing can entail. With the right IRA broker, nearly every investment imaginable is available to you.
By consolidating this roll-out with any other IRAs you may have you can reduce account proliferation. That can help focus plus potentially reduce costs further, as you'll have a bigger account to work with. It also reduces the risk the account is forgotten, either by you or your heirs after your death.
3. Integrate it With Your Other Holdings
Don't invest your 401K in a vacuum, as if that's the only account you own. That's the problem with settling for many default options, based only on your age. For example, you may have plenty of stocks elsewhere, and need to focus on fixed income. A healthcare oriented mutual fund may not make sense if you're set to inherit a boatload of Merck stock. Your financial profile may be stronger or weaker than is typical for your age, so accepting a one-size-fits all investment program in your 401K, even if customized for your age, may be the wrong approach.
The correct approach is to create a spreadsheet of your assets. Then, develop a game plan for the entire nest egg. Only then can you invest your 401K so it plays the right supporting role.
4. Reduce the Diversification
The usual mantra is diversify, diversify when it comes to investing. Not so when it comes to mutual funds. That's because each mutual fund typically contains hundreds of stocks. It's typically managed to be a stand-alone portfolio; single stock risk is virtually diversified away.
So, adding another stock mutual fund to your 401K typically results in duplicated positions. Fund A may own Merck and decide to sell while Fund B buys. The left hand doesn't know what the right hand is doing. You end up paying for transactions that are not sharpening focus but merely canceling each other out.
The problem can even occur with a domestic fund and an overseas fund, because so much of investment return is driven by the sectors involved, not the location of the companies. Thus, if domestic Fund A decides to buy Exxon to take advantage of rising oil prices, international Fund B may be selling BP in anticipation of falling oil prices. At the end of the day, your portfolio's focus is dulled but expenses are higher.
So, make sure each fund in your 401K is truly necessary. Less is more when it comes to your 401K funds.
To continue reading David Dietze's 12 Tips for a Better 401K, please click here.