Last week we took a look at tax advantages and rules to remember for 401(k) plans. This week we will discuss the nuts and bolts of using a 401(k), including contributions, investment options, and beneficiaries.
Using your 401(k) plan requires that you select a contribution amount, investments, and often, a rebalancing frequency. You should also select beneficiaries for your account in the event of your death.
Generally you want to contribute the maximum amount to your 401(k) account that your cash flow allows, given your circumstances.
The tax savings from your contribution and whether your employer makes a matching contribution are two important factors in deciding how much to contribute.
Reduce taxable income: Here’s an example of how contributions to an employer 401(k) can reduce your taxable income. Let’s assume a married couple has total household taxable income of $180,000 and files joint tax returns. For simplicity, let’s also assume that one spouse is under 50 years old and will contribute the maximum allowed amount to a 401(k) plan.
- Taxable income: $180,000
- Federal income tax bracket: 28%
- California income tax bracket: 9.3%
- 401(k) contribution: $18,000
- Taxable income after 401(k) contribution: $180,000 – $18,000 = $162,000
- Federal tax savings: $18,000 x 28% = $5,040
- California tax savings: $18,000 x 9.3% = $1,674
- Total tax savings: $6,714
- Net cash out of pocket to make 401(k) contribution: $18,000 – $6,714 = $11,286
The couple saved an impressive $6,714 in federal and state income tax by making an $18,000 contribution to a 401(k) account. The couple could save more if the second spouse also contributed to a 401(k) plan.
Because the 401(k) contribution reduces the couple’s income tax, the out-of-pocket cash the couple spends to make the contribution is reduced by the tax savings, or $6,714. Therefore, the contribution actually “costs” the couple only $11,286 instead of $18,000. This is an important aspect of 401(k) plans that many people don’t consider when deciding how much to contribute: The actual cash you must contribute will be less than you think because of the tax savings. This can allow you to contribute and save more than you might otherwise think you would be able to.
Receive “free” money: Some employers offer to match a portion of employee 401(k) plan contributions as part of their overall benefits package. If your company offers a match, as a general rule you should contribute at least enough to receive your employer’s matching contribution. The matching contribution is “free” money, and contributing enough to your plan to receive the match is equivalent to giving yourself a pay raise. The only drawback to this free money is that it will be invested in your 401(k) plan with your contributions and subject to the same distribution rules. In particular, you won’t be able to withdraw the employer contribution amount without penalty until you reach age 59½.
There are many formulas in use to calculate employer matching contributions. One common formula matches an employee’s contribution up to a percentage of the employee’s compensation. For example, Apple’s 401(k) plan has a generous match equal to 100% of an employee’s contribution up to 6% of compensation. Matching formulas may even have multiple tiers, which can be confusing. Here’s an example of a two-tier matching formula where the employer matches the employee contribution on the first 3% of the employee’s compensation and matches one-half of the contribution on the next 2% of the employee’s compensation:
- Compensation: $100,000
- Employee contribution: $18,000
- Employer matching contribution:
- 100% on first 3%: 100% x 3% x $100,000 = $3,000
- 50% on next 2%: 50% x 2% x $100,000 = $1,000
- Total employer matching contribution: $4,000
- Total contribution: $22,000
As long as this employee contributed 5% of their compensation to their 401(k) plan, they would receive a total match of 4%. This is an example of a “stretch match” formula designed to encourage employees to contribute more to their 401(k) plan. To receive the full $4,000 of “free” money, this employee must contribute $5,000 to their 401(k) plan. Said another way, by contributing enough to earn the matching contribution, this employee earns an 80% return on their contribution each year, risk-free.
Employee contributions to a 401(k) plan are always vested immediately. That means that the money you contribute is yours. Employer contributions that are so-called “safe harbor” matching contributions are also vested immediately. Certain employer contributions such as discretionary profit-sharing contributions may be subject to a vesting schedule and only become yours over time.
Your 401(k) plan will provide a set of investments to choose from. The number of investment choices in a typical 401(k) plan is about 20, which is usually enough to build a well-diversified portfolio without being overwhelming.
The investment options are most often a list of publicly traded mutual funds, which you can research within your 401(k) website or by using publicly available information from financial information providers such as Morningstar.com. Your investment options might also include less well-known collective investment trusts (CITs) or exchange-traded funds (ETFs), which are becoming more prevalent. CITs are private pooled investments and are more difficult to research because they are not publicly traded.
You will need to select a number of investments from the list of choices and decide what amount to invest in each. The amounts to invest are usually entered online by specifying a percentage of the total. For example, you might decide that the Dimensional U.S. Small Cap Value Portfolio, Institutional Class (ticker: DFSVX) should be equal to 7% of the total account value. So you would enter 7% next to DFSVX on the input screen. You would repeat that process for each investment you select. (The process for selecting individual investments from the list of options is a large topic by itself and is not covered in this article.)
Target date funds: Your 401(k) plan’s investment options might include a selection of “target date” mutual funds. Target date mutual funds often include a number in their name that represents the year in which you plan to retire. For example, Vanguard’s Institutional Target Retirement 2030 Fund (ticker: VTTWX) might be used by people with a target date for retirement in 2030. Target date funds create a complete portfolio of investments for you within a single mutual fund. The mix of investments inside a target date mutual fund adjusts over time to make it less risky as you get closer to retirement. To select a target date fund, you would enter 100% next to its name on the input screen of your 401(k) plan website. Even though you are selecting only one mutual fund, you will have a well-diversified portfolio inside of that mutual fund. There is no need to select additional mutual funds to get more diversification. (There is debate among retirement plan advisors about whether target date funds are the right choice for most people even as their popularity continues to grow.)
Static risk models: A final option that may be available to you in your 401(k) plan is professionally designed model portfolios. These are known as static risk models because they typically do not become more conservative over time, as the target date mutual funds do. To use a static risk model portfolio, you would enter 100% next to its name on the input screen. For example, a model portfolio that best fit your investment needs might be named Aggressive Growth, and it might be made up 80% of stock mutual funds and 20% of bond mutual funds.
Expense ratios: No discussion of 401(k) plan investment options is complete without covering expense ratios. The expense ratio of a mutual fund or ETF is an annual fee charged to investors expressed as a percentage of the total assets of the fund. For example, the average expense ratio for stock mutual funds in the U.S. during 2015 was 0.68%. The expense ratio is the percentage of a mutual fund or ETF’s assets used to pay for the internal costs of operating the fund such as interest expense, operating expenses, and management fees. The expense ratio does not include any transaction fees for buying and selling the mutual fund or any initial or deferred sales charges (i.e., “loads”).
Expense ratios are a direct subtraction from the return you earn on your mutual fund or ETF investment. For example, if you selected a mutual fund for your 401(k) account that earned a 10% return during the past year and that mutual fund had a 1% expense ratio, then the return you earned was actually only 9%. All else being equal, select investments for your 401(k) with the lowest expense ratios.
Rebalancing: Once you’ve selected the percentages of each investment option for your portfolio, you may be offered the option to set a rebalancing frequency. Rebalancing is the process of buying or selling some of each of your investment options to restore each option to its original weighting in your portfolio. For example, a simple portfolio of two mutual funds might include an 80% global stock mutual fund and 20% broadly diversified U.S. bond mutual fund. During a period of rising stock prices, the global stock mutual fund will grow and become a larger percentage of the entire portfolio. For example, it may grow to 85% of the total, leaving bonds at 15% of the total. Rebalancing is the process of selling some of the global stock mutual fund to bring its percentage back down to 80% from 85% and buying the U.S. bond mutual fund to bring its percentage back up to 20% from 15%. Many 401(k) plan websites offer rebalancing frequencies of annually, semiannually, and quarterly. If there are no transaction or other costs associated with rebalancing, selecting the most frequent rebalancing option is preferred. If your 401(k) plan website does not offer an automatic rebalancing option, you will need to rebalance your 401(k) investments manually at least once per year.
Your 401(k) plan beneficiaries are the people who will receive your 401(k) account in the event of your death. If you do not select a beneficiary, the 401(k) plan document will determine whether your account will be paid to your estate or to a default beneficiary such as your spouse if your spouse survives you. To ensure that your 401(k) goes to the people you want it to go to in the event of your death, designate a beneficiary or beneficiaries for your account. This is usually done online on the 401(k) plan website or by paper form held on file by the employer. Along with beneficiaries, you often have the option to name contingent beneficiaries in the event the primary designated beneficiaries unexpectedly pass away.
A 401(k) plan is a powerful tool to save and invest for retirement. When using your employer’s 401(k) plan, we recommend contributing the maximum amount your cash flow will allow. Your contributions will reduce your taxable income, allow you to collect your employer’s matching contribution if offered, and allow your savings to grow more quickly in this tax-deferred account.
In selecting investments, choose one of the professionally designed model portfolios, if available, or use a target date fund unless you’ve educated yourself on investments and you are comfortable building a portfolio from individual mutual funds (or have help from a qualified financial advisor). If you select individual investments, be sure to enable auto-rebalancing if available or manually rebalance at least once a year. And perhaps most importantly, complete a beneficiary designation form either online or on paper so your account will go to the people you wish in the event of your death.