Advanced Personal Finance

Yes, it’s only the beginning of October, but I’ve already seen Christmas trees and decorations for sale in stores. In that same spirit, here’s a brief look at what’s in store for 401(k)s in 2008.

2008 401(k) Contribution limits

The maximum you can contribute in a 401(k) (not including employer match, if any) in 2008 is $16,000. Add $5,000 if you’re over 50.

Safe Harbor plans

January 2008 is the first time companies with automatic enrollment can offer what’s called a Safe Harbor plan. This page gives all the gory details, but the gist of it is that employer matches in this type of plan (and they must have a match) must be automatically vested. Why would a company do this? It’s not benevolence. It allows highly compensated individuals to get around caps on their contributions when not enough worker drones contribute to the plan.

These safe harbors have to automatically enroll employees in the 401(k) (unless they opt out) at at least 3% of their salary. Contributions then have to be increased by 1% per year until the employee is putting in 6% to 10% of their salary.

Default investment selection

As part of the Pension Protection Act that generated a lot of changes in the 401(k), the U.S. Department of Labor is expected to outline rules for making a ‘target date’ fund the default investment selection for workers in plans. Obviously, you can change that to whatever you want, but even if someone never makes any active decisions, they’ll be on the right track for retirement saving.

Investment advice

A provision that I’m dubious about begins in 2008. Starting then, plan providers can offer in-person investment advice. Supposedly, to keep the bias out of it, this advice is to be based on a computer model or given by a fee-only planner. Who programs the computers is left unsaid.

At any rate, I’ll be interested to see how these advisors will deal with the fact that many employer matches are in company stock. I strongly believe you should sell most or all the company stock in your 401(k) as soon as you possibly can. I wonder if these advisors will recommend the same thing.

Photo credit: Sequim Washington Daily Photo

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Most of the time when you read about 401(k)s, it’s something like, “contribute at least up to the company match,” or, “don’t put too much in company stock.” But what do you do when your company’s 401(k) sucks?

Problem: Your company doesn’t offer a match.

Solution: Contribute as much as you can to a Roth IRA, then contribute to your 401(k).

I recommend maxing out a Roth IRA before contributing to a Traditional 401(k). The reason is that Roths are funded on an after-tax basis, but you withdraw the money at retirement tax free. I believe most people will be paying more taxes in the future, so a Roth is usually the best solution.

I also recommend contributing to a Roth IRA even if your plan offers a Roth 401(k). The reason is because you can always withdraw your contribution to a Roth IRA without penalty before retirement if disaster strikes and you need the money.

After you max out the Roth IRA, go back to your 401(k) plan. A 401(k) has great tax benefits. It reduces your current taxable income. Your contributions compound tax-deferred or tax-free, depending on with type you use (Traditional or Roth). It’s also an easy, automatic way to save for retirement. A company match is nice, but it’s not the best reason to use a 401(k) to save for retirement.

Problem: Most or all of the funds offered in your plan suck.

Solution: Figure out just how bad the funds are and decide if saving outside a 401(k) makes more sense.

Great, so how do you do that?

I’d consider a fund ‘bad’ if it has higher-than-average fees for its type and middling or below returns compared to its peers over many different time periods. If just some of the funds in your plan fit that description, invest instead in the ones that are good, even if it means overweighting your asset allocation. That is, if you’re offered a good stock fund in your plan, but no good bond funds, go ahead and invest in the stock fund. Outside your 401(k), say in an IRA, you can overweight bonds to compensate.

If truly all of the funds are bad, you have to consider not contributing to the 401(k) at all. Before you do, though, consider any employer match. If you’re offered a match, you’re almost certainly better off contributing to the match maximum and investing in bad funds. That’s because the immediate 50% or 25% return a company match gives you counteracts the general suckiness of the fund you invest in. For example, if you’re offered a 50% match on contributions up to 6%, go ahead and contribute the 6%. Even if your fund returns -20%, you’re still netting a positive 30% return - great by any standard.

So what if you have the worst situation of all - the funds suck and there’s no company match? In that case, there’s a very good chance you’d be better off not contributing to the 401(k) at all. Instead, invest in an IRA. I recommend a Roth IRA, but Traditional is good, too. That way, you can choose any fund you want.

Problem: Your match is in company stock and the stock is going nowhere.

Solution: Sell your company stock as soon as you can.

In 2006, Congress passed the Pension Reform Act that allows 401(k) participants to sell company matching stock. For stock given before the law was passed, you can sell 1/3 of the total each year over three years. For future matches, you can sell immediately. I advocate selling matching stock as soon as you can anyway, but this is especially true if the stock is declining or flat.

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The Roth IRA has one distinct advantage over the newly-arrived Roth 401(k).

With a Roth IRA, you can withdraw your initial investment fee- and tax-free at any time. Not so with the Roth 401(k). You can’t withdraw your contribution to a Roth 401(k) until you actually retire.

Should you want to withdraw your contribution from your Roth IRA, simply contact the financial services company where you invest and tell them what you want to do. They’ll be able to tell you the amount you’ve contributed if you don’t remember. Let them know your intentions and they can set the whole thing up. It’s very straightforward.

Now don’t get me wrong. I love the Roth 401(k) and invest a majority of my 401(k) contributions in it. With a Roth (either the 401(k) or IRA) you get your contribution and its gains tax-free at retirement. Pay no taxes on your retirement money - awfully sweet deal if you ask me.

Most people agree, which is why you’ll continually see the advice to fund a 401(k) to the employer match then switch to a Roth IRA. I don’t completely agree, though. I think the better technique is to fully fund your 401(k) then put money into a Roth IRA.

The reason is simplicity. If you have to take two actions every year - fund the Roth IRA and modify your 401(k) contribution somewhere during the year - it’s less likely you’ll actually do it.

So when comparing directly, the Roth IRA has the distinct advantage of your being able to get at your contribution before retirement. Though I don’t recommend raiding your IRA for spending money, a Roth IRA can function as a back-up emergency fund. There are different rules for withdrawing money before retirement from a traditional IRA.

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There’s a cool way to save money on taxes when you retire. I (and most readers, I imagine) don’t have immediate use for this little trick, but I’m posting it for my own future benefit. Anyway, it’s a little-known technique called Net Unrealized Appreciation. It works like this.

When you leave you job, either at retirement or for any reason (as long as you’re 55 or over), and you have 401(k) money in company stock, you can take a distribution and save money on taxes.

Typically, it’s a really bad idea to take a distribution from a 401(k) - and that’s still true if you’re under 55 because you’ll pay the 10% penalty - but here it can work to your advantage. You can use the original cost basis for the company stock portion of your 401(k) to set your tax floor. An example is probably better than trying to explain it.

Let’s say you’re finally retiring to concentrate on your Hummel figurine collection. Because you didn’t read my post on selling your company stock right now, your 401(k) contains company stock worth $200,000. Your cost basis, though, is $90,000, meaning you have a net unrealized appreciation of $110,000. Instead of rolling over the entire amount to an IRA, you take the stock portion as an in-kind distribution. You pay taxes on the $90,000 as ordinary income, but the $110,000 is taxed as a long term capital gain.

As long as your tax rate is greater than the long term capital gains rate (which is 15% right now), you save money on taxes.

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The company I work for froze our pensions a couple of years ago. Now there’s rumor that retirees will soon lose their health benefits (these kind of rumors are almost always right). People here and elsewhere bemoan these developments and heap curses upon our executives for cheating them out of their retirement benefits.

I hate to be the one to break this to you…

Pensions and pension benefits are gone and they’re not coming back.

I don’t say this in a snooty ‘I’m saving for retirement, why didn’t you’ tone. You think I like losing money and benefits? Hell, no. I think it’s tragic. But it’s a fact.

I feel particularly bad for people around 50 in situations like this. What’s left of their pension isn’t nearly enough to live on and they probably haven’t been saving in a 401(k). If they have, those savings simply haven’t had much time to compound.

Is there any hope?

For people caught in the gap between ‘enough time to save on their own for retirement’ and ‘we got our pensions,’ there’s sadly little for them to do. Sure, there’s the catch-up provision on IRAs and 401(k)s. But there are still two problems with that - most people don’t contribute enough to get to the regular IRS maximum and even if they did, $5,000 (for a 401k) or $1,000 (IRA) more per year just ain’t that much.

For everybody else, check out this simple way to calculate if you’re saving enough for retirement. If you’re not, there’s still time. The Roth 401(k) is good for saving - use it. Put money away in your IRA. Do what you can, because relying on the promise of a pension is not a plan.

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