Monday, November 9, 2009

Time, Transfers and Temptations: The Overcomplicated 401(k)

While the 401(k) plan you have access to at your place of employment is a a "better-than-nothing" retirement plan doesn't mean that you should ignore the benefits of investing for your future.

There are three basic problems with the retirement plan (and how you use it) known as the 401(k).

First, for many of us, it has not been around long enough for us to take full advantage of what this type of investment scheme can offer. A full thirty years or more would be considered the optimum amount of time - which makes this a young investors game. The older investor probably has had less than fifteen years to date to grow a plan that they believe will provide enough post-work income to allow them to retire well.

People who do not have that much time should be attempting to max out the plan (either the most you can contribute or the most the IRS will allow) and keep more than what those sage financial planners suggest in stocks. Even if the equity exposure is spread across a variety of index funds, moving too much into a conservative investment such as fixed income too early will drive the available balance and potential earnings down.

For people who are in this age bracket, the focus should shift to getting your financial house in order while you have the time. Set your mortgage up for payoff as soon as possible. This can be done a number of ways: refinancing or paying down the mortgage in advance of the scheduled payoff date. While a refi is good, unless you are getting an interest rate reduction of one percentage point of better, the cost of a new loan and the ability to get one in this sort of slumping economy might not be the best way to spend those dollars.

Instead, begin a prepayment plan that is both safe and easy and has the most flexibility. For instance, did you know that if you pay one extra month a year (divided over twelve months payments - $1200 a month mortgage payment divided by twelve would allow you to make a $1300 payment) would shorten the length of the loan by eight years? A fourteenth month payment would bring the total length of the loan down to about sixteen years. This is without costly refinancing and allows you to do what you can if you can afford it. Avoid the lenders offer of a twice-a-month payment plan and secondly, be sure that when you do this, mark the extra payment as "for principal".

Do I need to tell you to do what you can to eliminate any and all outstanding credit? If you cannot payoff what you have borrowed at the end of each month, you have borrowed more than you can afford.

Secondly, your retirement account is not a savings account. It is an investment for your future. Not one single dime should be withdrawn for any other purpose than your retirement. When you are transferring a 401(k) due to a job loss or a new job, make sure you roll it over into an IRA and name a Trust or Trustee. Failure to do so will result in taxes charged against you as if you had simply withdrawn the money.

And lastly, you will not be able to invest as much but the opportunities are greater. IRAs will not provide you with as great of a pre-tax advantages as your 401(k) did, but the choices you will have as result of getting out of not-so-good plan are incredible. Shopping on the open market for a mutual fund or funds allows you to move your move across the full breadth and depth of the market, control the expenses and fees and allow you to set your goals (in terms of risk) far better.

Many 401(k) plans force employees to purchase company stock which make them less diversified. Getting out from under this type of plan will stand to be the best thing that changing jobs could offer. Granted, if your company matched contributions (some still do and many more will begin to do so again in the next several years) this will no longer happen. This is a big loss of free money. Use this as a criteria for your next job and insist it be part of the benefit package.

You can still set up an automatic payments withdrawals from your checking or savings account but there are limits. In 2010, the limit for your IRA, which is what your new rollover plan is called, will be $5,000 for individuals and $6,000 if you are over fifty. You could, if you can afford to do so, open a Roth IRA as well (a rollover into a Roth will prompt a tax penalty because Roth plans are after tax accounts). This will allow you an additional $5,000 contribution.

Keep in mind that you only have a sixty day window to do this. Your old employer may allow you to stay in your old plan. The 60 days begins when you start the action or they tell you they want you out.

What to keep in mind about your 401(k) plan and rollovers:
If you have a 401(k) plan use it and if possible, use it to its fullest.
Get your financial house in order while you are working, especially if you have only been in your 401(k) plan for less than fifteen years.
Rollover your old 401(k) into a Traditional IRA within 60 days and be careful with the paperwork. If you have more money to invest, open a Roth as well.

Paul Petillo is the Managing Editor of and a fellow Boomer

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