Getting Started in Rebuilding Your 401(k) Account E-Book

Paul Katzeff

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The Getting Started In Series
• Sprache: Englisch

Seitenzahl: 454

Veröffentlichungsjahr: 2010

Beschreibung

The essential guide to getting a 401(k) plan back on track While a majority of workers have money invested in their 401(k) plans-and are relying on these funds for retirement-few truly understand how to manage and maintain these accounts, especially during the recent economic downturn. In 2008 alone, most 401(k) holdings declined by twenty percent. These losses, compounded by plan changes, have only led to more confusion. The Second Edition of Getting Started in Rebuilding Your 401(k) Account offers up-to-date answers to frequently asked questions regarding these accounts and contains simple strategies for improving 401(k) returns-including moving money out of company stock, rolling over plans when leaving an employer, and moving some holdings to FDIC insured banks. * Explains the basics of 401(k) plans from what they are to how they work * Discusses new rules in the 401 (k) arena, from automatic enrollment to how plans can be taxed * Includes information on setting financial goals and choosing the investments that are right for you 401(k) plans have become a significant source of retirement funds for many. Learn how to make the most of them with the Second Edition of Getting Started in Rebuilding Your 401(k) Account.

Leseprobe

Table of Contents

Books in the Getting Started In Series

Title Page

Copyright Page

Acknowledgements

Introduction

Their Payoff Makes Them Increasingly Popular

Growing Money with Your 401(k) Plan

401(k) Investing for “the Rest of You”

Making It Easy to Understand

Part 1 - Understanding Your 401(k) Plan

Chapter 1 - Basics of Your 401(k) Plan

A Closer Look at Those Three Key Advantages

More Ways a 401(k) Plan Can Help You

Chapter 2 - Time and Money: Your Plan’s Wealth-Building Weapons

Give Your Money Time to Grow

A Pricey Problem to Avoid: Making Up for Lost Time

Tax Deferral: How It Makes Your Money Grow Faster

Your Advantage Grows Over Time

A Company Match

Put It All Together

Chapter 3 - Understanding More of the Advantages

Automatic Payroll Deduction

How Much You Can Invest: Government Limits

How Much You Can Invest: Your Plan’s Limits

Choosing Your Own Investments

Fine-Tuning Your Agenda

More Features of Your Plan

Roth 401(k) Account Contributions

Learning About Your Options

Chapter 4 - Borrowing from Your 401(k) Account

Basics about Borrowing

Advantages of Borrowing

Disadvantages of Borrowing

What Is the Most You Can Borrow?

Watch Out for No. 1

Chapter 5 - Hardship Withdrawal

Uncle Sam’s Game Plan

More Red Tape

Tax Fallout

Your Last Resort

Compared to Borrowing from Your Account

Biggest Disadvantage

Chapter 6 - ABCs of Participation

Eligibility: When You Can Join

Vesting: How Soon Is the Money Yours?

Portability: You Can Take It with You

After-Tax Contributions

Chapter 7 - Making Participation Easier: Automatic Enrollment

Default Options

Chapter 8 - Learning Your Way around Your Plan

Who’s Who

Your Best Sources of Information

Information Blind Spot

Bottom Line

Chapter 9 - How to Withdraw Your Money

IRA Rollover

Installment Payouts

Taking Your Money in a Lump Sum

Ten-Year Forward Averaging

Leave Your Money in Your Company Plan

Payouts Whenever You Want

Bottom Line

Chapter 10 - Roth 401(k) Accounts

Back to Basics

Cutting to the Chase

Taxes and Penalty

Distributions

Odds and Ends

Chapter 11 - Single-Participant 401(K) Plans

Income Requirements

Part 2 - Setting Your Financial Goals

Chapter 12 - How Taxes Can Take a Bite from Your Payouts

Before 59½: Early-Withdrawal Penalties

Payouts after Age 70½

Chapter 13 - Living on Less

Pieces of the Puzzle

Getting By on Less

Plan Ahead

Chapter 14 - Measuring How Much Income You Will Need: Making Your Retirement Budget

Follow This Blueprint

Measuring Your Expectations

Cutting Back, Spending More . . . Let’s Count the Ways

Your Retirement Budget: Filling In the Blanks

Taking the Next Step

Chapter 15 - How Much Money Do You Need to Save? Use the Retirement Savings ...

How Much You Need to Contribute

Retirement Savings Work Sheet

Part 3 - Making a Game Plan—and Winning

Chapter 16 - Inflation: What It Is, How It Erodes Your Money, and Ways to Cope ...

Understanding Inflation

Melting Money

The Race against Inflation

Coping with Inflation

Chapter 17 - Invest for the Long Haul

Be Aggressive, Unless . . .

Risk and Reward

The Difference between Risk and Fear

Time Is Money

Chapter 18 - Invest for Steady Growth

How Funds Are Categorized

Don’t Be Seduced by Nearsighted “Best Of” Lists

Look for a Winning Category

Aim for Long-Term Growth, Not Short-Term Fireworks

Think Long-Term

Chapter 19 - Plan Ahead: Investment Strategy, Goals, and Time Horizon

Two Schools of Strategy: Choose One

Buy-and-Hold

Asset Allocation

Choosing Your Investment Goals

Time Horizon

Chapter 20 - What Is a Growth Stock Fund, Anyway?

Growth Is Job No. 1

Types of Growth Funds

Types of Income Funds

Fixed-Income Funds

Chapter 21 - How to Pick a Growth Stock Fund

Growth Fund Heavy Hitters

Cutting to the Chase

Look for Endurance

Chapter 22 - Premixed Funds

Target-Date Funds

Target-Risk Funds

Look before You Leap

Chapter 23 - How to Do Your Investment Research

How to Check Out a Fund

Expenses

Chapter 24 - Taking Care of Your Account

How Many Funds Are Enough?

When to Sell a Fund

Beware of Scams

Annual Checkup

Chapter 25 - Navigating Through Tough Times

Coping with Cutbacks

Plan Ahead

Boosting the Odds of Reaching Your Goal

More Bang for Each Buck

Precautions against a Pink Slip

Chapter 26 - Sources of Information

Newspapers and Web Sites

Magazines

Specialty Research Sources

Selected Information Sources

Index

Books in theGetting Started InSeries

Getting Started in Online Day Trading by Kassandra Bentley Getting Started in Asset Allocation by Bill Bresnan and Eric P. Gelb Getting Started in Online Investing by David L. Brown and Kassandra Bentley Getting Started in Investment Clubs by Marsha Bertrand Getting Started in Internet Auctions by Alan Elliott Getting Started in Stocks by Alvin D. Hall Getting Started in Mutual Funds by Alvin D. Hall Getting Started in Estate Planning by Kerry Hannon Getting Started in Online Personal Finance by Brad Hill Getting Started in Internet Investing by Paul Katzeff Getting Started in Security Analysis by Peter J. Klein Getting Started in Global Investing by Robert P. Kreitler Getting Started in Futures, Fifth Edition by Todd Lofton Getting Started in Financial Information by Daniel Moreau and Tracey Longo Getting Started in Emerging Markets by Christopher Poillon Getting Started in Technical Analysis by Jack D. Schwager Getting Started in Real Estate Investing by Michael C. Thomsett and Jean Freestone Getting Started in Tax-Savvy Investing by Andrew Westham and Don Korn Getting Started in Annuities by Gordon M. Williamson Getting Started in Bonds, Second Edition by Sharon Saltzgiver Wright Getting Started in Retirement Planning by Ronald M. Yolles and Murray Yolles Getting Started in Online Brokers by Kristine DeForge Getting Started in Project Management by Paula Martin and Karen Tate Getting Started in Six Sigma by Michael C. Thomsett Getting Started in Rental Income by Michael C. Thomsett Getting Started in REITs by Richard Imperiale Getting Started in Property Flipping by Michael C. Thomsett Getting Started in Fundamental Analysis by Michael C. Thomsett Getting Started in Hedge Funds, Second Edition by Daniel A. Strachman Getting Started in Chart Patterns by Thomas N. Bulkowski Getting Started in ETFs by Todd K. Lofton Getting Started in Swing Trading by Michael C. Thomsett Getting Started in Options, Seventh Edition by Michael C. Thomsett Getting Started in A Financially Secure Retirement by Henry Hebeler Getting Started in Candlestick Charting by Tina Logan Getting Started in Forex Trading Strategies by Michael D. Archer Getting Started in Value Investing by Charles Mizrahi Getting Started in Currency Trading, Second Edition by Michael D. Archer Getting Started in Options, Eighth Edition by Michael C. Thomsett Getting Started in 401(k) Plans, Second Edition by Paul Katzeff

Copyright © 2010 by Paul Katzeff. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

A previous edition of this book, Getting Started in 401(k) Investing by Paul Katzeff, was published in 1999 by John Wiley & Sons.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Katzeff, Paul, 1948-

p. cm.—(Getting started in)

Rev. ed. of: Getting started in 401(k) investing. c1999.

Includes index.

ISBN 978-0-470-48582-8 (pbk.)

1. 401(k) plans. I. Katzeff, Paul, 1948- Getting started in 401(k) investing. II. Title.

HD7105.45.U6K37 2010

332.024’0145-dc22

2010012325

Acknowledgments

I wish to thank the many people who helped make this book a reality. In particular: Wes Mann, Susan Warfel, Chris Gessel, and Paul Sperry of Investor’s Business Daily for their collegial support; Doug Rogers of IBD for invaluable feedback; Carrie Coghill of D. B. Root & Company, whose significant contributions made the income work sheet possible; David Wray of the Profit Sharing/401(k) Council of America for his generosity of time and input; Lipper, Inc., CDA/Wiesenberger, Hewitt Associates LLC, The Vanguard Group, Spectrem Group, T. Rowe Price, Putnam Investments, Morningstar Inc.,1 and Towers Perrin for data; Don Roberts of the IRS; Gloria Della and Sharon Morrissey of the U.S. Department of Labor; and Clark M. Blackman II, then of Deloitte & Touche LLP, for his extensive contributions regarding tax consequences of distributions. I also want to thank the following for their in-depth contributions, generosity of time, and patience with my questions: Stuart Ritter, Christine Fahlund, Jesse Wilson, and Brian Bankert of T. Rowe Price, whose contributions included explanations of the ins and outs of Roth 401(k) accounts, of single-participant 401(k) plans, and of savings strategy; Tom Foster of The Hartford, for translating the intricacies of vesting rules into plain English; Jeff Maggioncalda of Financial Engines and Stephen Utkus of Vanguard Group for their expertise regarding automatic enrollment; John Ameriks of Vanguard Group for advice about coping with market gyrations; Ralph Vizl of John Hancock Retirement Plan Services for detailing safeguards against fraud; Ed Slott, editor of “IRA Advisor” newsletter; Mark LaVangie, IRA technical consultant with Ed Slott and Company; Tom Kmak, chief executive of Fiduciary Benchmarks, for calculations comparing tax impact on savings inside a 401(k) account vs. a taxable account; and Mark Nash, personal finance partner in PricewaterhouseCoopers private company services, for detailed explanations of distributions, and Debra Englander of John Wiley & Sons.

I also want to thank my friends and family for their patience. And, of course, Janet for her encouragement and patience (yet again) while I invested so many of our hours into this book.

Introduction

Hopping onto the 401(k) Bandwagon

Picture yourself in a perfect world. . . .

Your bank account is bigger than the sultan of Brunei’s.

You love your job, and you’ve got a great pension plan.

You’re looking forward to retirement, when you can move to your dream home in a crime-free community.

You’ll spend sunny mornings on the golf course with your spouse. Afternoons, you’ll go fishing aboard your cabin cruiser . . . or work on your tennis game back at the country club. Saturday mornings you’ll make handsome furniture for your grandchildren in your lavishly equipped basement workshop . . . or volunteer at the local hospital. A few nights each week, perhaps you’ll enroll at the nearby college in that philosophy class you’ve always wanted to take.

Don’t forget weekend evenings. That’s when the two of you will drive into the city for dinner at a fine restaurant. After coffee and dessert, you’ll head to the concert hall to enjoy the local, world-famous symphony.

And did we mention that your health is fine, thank you, and you’re looking forward to making Willard Scott’s 100th-birthday greeting list? All those years, your living expenses will hardly make a dent in that huge bank account of yours. Besides, you’ll have your pension checks and Social Security.

Ahhhh. . . . The good life.

Now imagine the real world.

Your bank account is smaller than the sultan of Brunei’s butler’s. Much smaller.

How small? Well, the average American bank account holds only $3,800, according to the Federal Reserve Bank. That won’t buy much if you try to spread it over, say, 20 years of retirement.

And chances are your checking or savings account holds a lot less. That’s because the $3,800 average includes the bank accounts of such deep-pocketed depositors as Microsoft and AT&T. For the zillion-dollar accounts of those corporate colossi to average out below five figures, imagine how little is in most people’s passbooks. A balance, say, of $100 or $500 won’t cover golfing greens fees for more than a month or so, let alone living expenses for decades of retirement.

Your pension plan? The bad news is it may be headed for extinction. Worse, it won’t pay for much, anyway.

Barely 25 percent of the traditional pension plans that were run by private businesses in 1985 still exist. Fewer than 29,000 remain.2

Anyway, a pension won’t pay much. Yearly private-sector pension income for retirees 65 or older averages merely $11,605, according to the Congressional Research Service.

And Social Security? Its own future is not very secure, let alone its ability to provide for yours. Even if it somehow survives until the time you retire, it won’t pay for much.

Millions of baby boomers marching into retirement are expected to push the system into red ink in 2017 or earlier, and by 2037 the system is projected to go flat broke, according to the Social Security Administration.

If the rickety system pulls off a miracle and clings to life support, it certainly won’t pay for much.

How feeble is the outlook? Suppose you’re a single 45-year-old, whose annual salary is $100,000. Let’s say you average 2 percent yearly pay raises until you retire at 65. Congratulations. You’re in line for a monthly benefit of $2,906. That’s not quite 35 percent of your current pay. It’s less than 24 percent of your $145,681 salary the year you retire.

Go ahead, be a sport. Round it off to 25 percent. With your lifestyle, that’ll be enough to afford food every fourth day, turn lights on at home the first week of every month, and pay your mortgage every fourth month.

Their Payoff Makes Them Increasingly Popular

Getting the picture?

Unless you are the sultan of Brunei, you’ll need a 401(k) plan—now—to provide income in retirement to buy groceries, pay your Florida condo fees, and gas up the car.

And that’s even if your spending goes way down once you retire. Most people, for example, get by on about 70 percent of their preretirement income.

If you plan to take any round-the-world cruises, pay all or part of your grandchildren’s college expenses, or even buy a new set of fancy golf clubs, you’ll need lots more.

Your best bet for getting more is from a 401(k) plan.

In comparison, bank accounts, pension plans, and Social Security look more and more like the proverbial 95-pound weaklings of retirement finance.

The typical 401(k) account now has been pumped up to $65,454, according to the Employee Benefit Research Institute, a nonprofit research organization. Better yet, nearly 19 percent of plan members have a cushy account balance of at least $100,000, EBRI says.3

The relative advantage of 401(k) plans is growing. Account sizes tend to rise over time. Before the most recent level, the average account size was:

• $61,346 in 2006.

• $58,328 in 2005.

• $56,878 in 2004.

Of course, there is no such thing as Santa Claus. And 401(k) account balances don’t increase every year. Accounts shrank in 2008 as stock values went into an ugly freefall. By one key measure, the stock market suffered its steepest decline since the Great Depression year of 1931.

401(k) account sizes also took beatings after the collapse of technology and Internet investment mania in 2000.

But over longer periods, the stock market rewards long-term investors, like 401(k) members, with growth

Workers recognize a good thing like this when they see it. Recognizing that their money can’t grow unless it is put to work, plan members have been boosting the amount they contribute.

The Profit Sharing/401(k) Council of America reports that:

• Rank-and-file workers now kick in 5.5 percent of their paychecks, on average. That’s up from 4.3 percent 15 years earlier.

• People high on the corporate food chain funnel an average of 6.6 percent of their pay, up from 2.8 percent.

Just a bunch of fuzzy numbers to you? If all those decimals and percentages just give you a headache and a stomach-jotting flashback to eighth-grade algebra class, think of them this way: Rank-and-file workers voluntarily increased their contributions by roughly 30 percent. Would you voluntarily jack up your home mortgage payments by that much? Or your weekly grocery bill?

That shows commitment. People understand the payback benefit.

For that reason, more people have been hopping onto the 401(k) plan bandwagon.

Nearly 49 million Americans now participate. As Figure I.1 shows, that is more than double the number of members in 1990, according to EBRI. The ranks of 401(k) plan enrollees are expected to continue to grow.

Take a closer look. Enrollment is not increasing just because there are more plans (there are) or only because there are more Americans working (there are). Plan membership is on the rise because more people understand the merits of joining. More eligible people want a piece of the action.

And new rules are speeding the sign-up parade even more. In late 2007 Uncle Sam gave the green light to employers that want to automatically enroll workers in their company plan, unless the worker expressly opts out.

FIGURE I.1 401(k) plan enrollment and assets keep rising.

Source: Employee Benefit Research Institute.

Before that new rule, plans with auto enrollment were typically able to enlist about 90 percent or more of eligible workers. Plans without auto enrollment saw participation stick in the 70 percent range.

As Figure I.2 shows, the allure of auto enrollment is already showing up in overall participation rates. Sign-ups jumped to 82.7 percent in 2008. They had been stuck in the high 70s for several years. They had even declined from a peak in the mid 80s during the 1990s.

So it is not only new workers who join plans. It is people who have had the right to join a plan but have not taken advantage of the opportunity.

Once they see how easy it is to save and invest . . .

Once they hear from recently retired friends about added retirement income . . .

Once they learn how pain-free it is to contribute automatically . . .

Once they jealously ponder their coworkers’ right to invest while reducing their taxes . . .

Once they realize how tough it is to depend on other sources of retirement income . . .

. . . More of them decide the time is right to sign up.

“If you want financial resources to pay for daily expenses, get into your 401(k) plan,” is the blunt advice offered by Dallas Salisbury, president of EBRI, a benefits-research organization in Washington, D.C.

“Social Security is a safety net. It was not intended as a national pension plan. And do not count on your traditional pension plan, either.”

If you’re even lucky enough to have a conventional pension plan, remember this: Companies use their plans to encourage worker loyalty. They couldn’t care less about your old-age comfort. Payment formulas commonly boost rewards only for the last few years of very long service. Many workers don’t stick around—or survive—that long.

FIGURE I.2 The percentage of eligible people who join a 401(k) plan is climbing again, thanks to recent new rules.

Sources: © Spectrem Group 1998; used with permission; Profit Sharing/401(k) Council of America.

“A traditional pension will only provide meaningful supplemental income to anyone with 25 or more years of employment,” says Salisbury. “Only about 15 percent of the labor force stays with one employer that long. Frankly, even if you’re in that 15 percent, you probably won’t get retirement medical benefits. So, if you want to protect yourself against medical disaster or just pay for health contingencies, you’ve got to build financial assets through an income source like a 401(k) plan.”

Growing Money withYour401(k) Plan

Americans are helping themselves not only by boarding the 401(k) bandwagon in greater numbers and by feeding more dollars into their accounts. They are also using their dollars more shrewdly.

Increasingly, people are investing in things that get better financial mileage.

One of Wall Street’s most basic lessons is that stocks (and mutual funds that invest in stocks) pay greater rewards over time than bonds (and funds that invest in bonds). And Americans are shifting their dollars into stocks and stock mutual funds.

That’s precisely the right thing to do. Getting Started in Rebuilding Your 401(k) Account, Second Edition, explains why stocks and stock funds perform better. The book also explains how to take advantage of that in your plan.

Bonds, bond funds, money market funds, and other related investments have a different role. Getting Started in Rebuilding Your 401(k) Account explains what that is, and how to benefit from that, too.

But relying on them for your primary investments during your working years can cost you big bucks in the long run. This book describes how to avoid that expensive—but common—mistake.

And you won’t need a Wall Street dictionary to understand what Getting Started in Rebuilding Your 401(k) Account is saying.

401(k) Investing for “the Rest of You”

Time out for a reality check. Right about now many of you are muttering, “Enough already.”

Numbers make your head spin. You don’t care about the growth of 401(k) plans. Paragraphs that promise to teach you how to invest make your eyes glaze over. At best, you’d love to learn about the differences between stock mutual funds and bond funds, but you don’t have the time.

And—be honest—perhaps just don’t care.

That’s okay. This book is for you, too. It’s not just for people who have the time and energy and desire to be regular participants in their workplace 401(k) plan, making more of their own decisions.

A big reason why this book is for you, too, is that key recent changes in 401(k) rules recognize that you are out there and that you have plenty of company. And those changes are designed to help you use your company’s 401(k) plan by eliminating decisions you don’t want to make.

So this book will help you understand those new rules, and how to make the most of your 401(k) plan—without doing the things you don’t want to do in the first place:

• Make up your mind about whether and when to join your company plan.

• Figure out which investments to choose.

• Decide what to do with your money at retirement.

Taking Advantage of Recent Changes

Many of the new rules are also helpful to regular plan members. Those are people willing to make common, key decisions that shape their account, such as when to join and what to invest in. The new rules can help long-time plan members, too. Still, even if you’ve had a 401(k) account for years or decades, you may not be familiar with all the new regulations and features. Don’t worry. I explain what you need to know about new wrinkles such as:

• Automatic enrollment.

• Automatic assignment of certain investments.

• Getting investment advice from your plan.

• Whether to choose a Roth-style 401(k) account or a regular account.

• Whether to select annuity income options offered by more plans.

• How self-employed entrepreneurs can set up their own 401(k) plan. If you are a small-business owner, whose only other potential employee is your spouse, your annual contributions can be much higher than the contributions most workers are allowed to make in regular plans.

Making It Easy to Understand

No matter how actively or passively you participate in your company’s plan, without a large enough retirement nest egg you will be in line for retirement’s ultimate booby prize.

“If you don’t prepare yourself financially, you’ll get the grand opportunity—to work forever,” warns Salisbury.

The alternatives are equally upsetting: postponing retirement, lowering your expectations—or getting used to the idea of panhandling.

This book will help you avoid all such dire consequences. Instead, you can aim for a more comfortable lifestyle once you know how to get the most from your 401(k) plan.

Getting Started in Rebuilding Your 401(k) Account does that by explaining in plain English:

• What a 401(k) plan is and how it works.

• The best and easiest way to make your money grow.

• How to choose investments that are right for you.

• Differences between lifestyle mutual funds and target-date funds.

• Dos and don’ts of using your account for nonretirement financial goals.

• Where your 401(k) plan fits into your overall retirement planning.

• How to get a handle on how much income you’ll need during retirement.

• How to minimize your taxes.

• How your 401(k) plan stacks up against—and can supplement—other retirement accounts like IRAs.

• What you need to know to avoid hassles and rip-offs.

• What to do if your employer falls on hard times and cuts its contribution to your account.

• What to do if your company folds or is bought out—or if an event like that seems increasingly likely.

You’ll find that information organized into three easy-to-understand sections:

Part One: “Understanding Your 401(k) Plan”

Part Two: “Setting Your Financial Goals”

Part Three: “Making a Game Plan—and Winning”

And don’t worry.

Learning how to make the most of your 401(k) plan is simpler than you might think. You won’t have to master any mysterious jargon. This book doesn’t use Wall Street lingo. It translates fancy terminology into down-to-earth language.

On your own, you’ll learn how your plan works and how to make your money grow.

You’ll learn how to do those things without having to wait for infrequent visits by representatives of your plan’s mutual fund or insurance company. And you won’t have to rely on your company’s human resources (HR) person. Even when they are well-meaning professionals, those people may not be able to answer your most important, personalized questions.

Getting Started in Rebuilding Your 401(k) Account will teach you to how to navigate your own way—at your own pace. Whether in the privacy of your own home or at your leisure aboard the commuter train, Getting Started in Rebuilding Your 401(k) Account will teach you how to use your plan and make investment decisions that suit your needs and goals.

Plain and simple, this book will help you build your retirement nest egg bigger and faster than you ever thought possible.

Part 1

Understanding Your 401(k) Plan

What It Is, How It Works, and Why You Need One

You’ve heard all about them—401(k) plans are almost everywhere. The only people who don’t seem to have them are professional football players and bank robbers. And you’re not so sure about the football players.

But you don’t know as much as you want to about your 401(k) plan. It’s for retirement money. It involves investments. And that may be about it.

Exactly how it works, what you’re entitled to, the dos and don’ts—it’s all a blur.

And it doesn’t matter whether you actually know a lot, only a little, or nothing at all.

If you’re already an avid participant in your plan, you can still use help in understanding certain features and in getting a handle on whether your investments are your best possible choices.

And most people know a lot less about their plan. After all, everyone has other time-consuming responsibilities, at work and at home. It’s tough enough to pay the bills without having to worry about stealing from your own paycheck to put money away for your retirement—which may be very far in the future. Besides, all that jargon can give most people a headache. And Wall Street? It seems like a very private club, with its own secret rules, located far, far away from where you live and work.

Part One of Getting Started in Rebuilding Your 401(k) Account explains what your plan is, how it works, and how it can help you.

And Getting Started in Rebuilding Your 401(k) Account does this in plain English. That may be a foreign language on Wall Street. But it’s what everyone speaks on Main Street, U.S.A.

Chapter 1

Basics of Your 401(k) Plan

Right here, right now, let’s cut to the chase.

Question: Why is your 401(k) plan important to your future?

Answer: Because it is a free pay raise.

If you don’t need money, you can stop reading. Go to the movies. Watch some TV. Walk the dog. Good-bye and good luck.

The rest of you, read on.

A 401(k) plan does indeed provide you with a free pay raise. In fact, by putting more money into your pocket up to three different ways, it gives you as many as three pay raises.

1. Your contributions can lower your taxes.

2. Your investments grow without being taxed year-by-year. You can plow those would-be taxes back into your investments.

3. Your company almost certainly matches your contribution with a bonus that goes into your account.

No other source of savings or income duplicates that triple play—not your savings, not your pension (if you’ve got one), not Social Security.

A 401 (k) Plan versus an IRA

An individual retirement account (IRA) comes closer than savings, pensions, or Social Security to matching a 401 (k). But even an IRA—whether it’s a Roth, a regular deductible, or a nondeductible—lags behind a 401 (k) plan account in two crucial ways:

First, the most you can contribute each year (even if you can double the amount with a spousal contribution) is much less than the amount you can put to work inside a 401(k) account under federal rules.

Second, an IRA provides no company match!

A Closer Look at Those Three Key Advantages

The edge that a 401(k) plan gives you has to do with how those three pay raises work.

Cuts Your Taxes

Money you contribute to a traditional or regular account is subtracted from your taxable current income. It is tax-deductible “before-tax” money. Not only do you get to invest it; it also reduces your taxable income that year. It may even put you into a lower tax bracket. Unless you are a monetary masochist who thinks bigger is better when it comes to taxes, this is a great deal!

Tax-Deductible Your traditional 401 (k) contribution is what accountants call “tax-deductible.” That’s because you subtract your contribution from your other taxable income. The amount left over is what you figure that year’s tax bill on.

Your contribution’s tax-cutting power is so important that it deserves to be talked about in a little more detail.

Think about it. Your 401(k) contribution puts money back into your pocket by doing two things:

1. It reduces your taxes.

2. The money you save on taxes can be invested so it grows—along with your contribution itself. It turns a loss into a gain. This is as close as you’ll ever get to the proverbial free lunch.

“Before-Tax” Money Because your contribution is made before your taxable income is calculated, your contribution is referred to as “before-tax” money.

Lowering Your Taxes

Here’s how a tax-deductible contribution helps you.

A tax deduction is taken into consideration while you are figuring out your tax bill. For instance, if you are in the 28 percent bracket, when you make a $2,000 contribution to your 401 (k) account, that $2,000 is not taxed. You save 28 percent of that $2,000, or $560.

Don’t confuse a tax deduction with a tax credit.

If you are entitled to a tax credit, you subtract it from your tax bill. After you calculate your tax bill, for example, a $2,000 tax credit reduces your taxes by $2,000. It doesn’t matter what tax bracket you’re in.

Best of Both Worlds

Your contributions to your traditional 401 (k) account are tax-deductible. It’s as if you did not earn the money. That lowers your current tax bill.

But your contributions are counted for purposes of calculating your Social Security and Medicare taxes. A tax payment of any kind may not exactly be cause for celebration. But it means that your 401(k) contribution is included in the calculation of how large your Social Security and Medicare benefits will be later in life.

Roth 401 (k) Account

Contributions to a traditional 401 (k) account are with before-tax (or pretax) money. That money is not counted in that year’s taxable income.

But now you can choose to use what’s called a Roth 401 (k) account, if your plan offers that option, either instead of or in addition to a traditional account.

A Roth 401 (k) account is like a Roth IRA. Contributions are made with after-tax money. That means they’re from money left over after you’ve paid taxes.

Once you contribute to a Roth 401(k), you won’t owe tax that year or in subsequent years on whatever that contribution earns in investments. Like a traditional or regular 401(k) account, earnings are tax-deferred.

The big difference between a Roth and a regular 401(k) account is what happens when you take money out. Withdrawals from a Roth 401(k) are not taxable. That’s because you already paid tax on the money before it went into the account. Withdrawals from a regular 401(k) are taxable.

Roth 401(k) accounts are discussed in detail in Chapter 10.

Additional After-Tax Account Options

Some plans let you make non-Roth after-tax contributions. Why bother? After all, they don’t lower your taxable income in the current year.

But such so-called nondeductible accounts give you another way to invest money so its earnings grow on a tax-deferred basis. You’ll only be liable for tax when you finally take money out. That may not happen for years or even decades, until you are retired.

Postpones Taxes on Your Investments

This is a humongous benefit. Not . . . paying . . . taxes. It used to be that only gangsters could pull that off. They had to send secret deposits to a numbered account in Switzerland.

Now all you have to do is join your 401(k) plan, not your local chapter of the Cosa Nostra.

This privilege is called tax deferral. It means that you escape current taxes on the money you invest each year. It also means you don’t have to pay yearly taxes on your 401(k) account balance or its investment earnings until you withdraw funds.

Tax Deferral That’s the name of the tax break that applies to your money so long as it’s inside your 401 (k) account.

Yes—eventually Uncle Sam expects to be paid. But not until you take the money out of your account. A gangster may never worry about paying taxes. But using a 401(k) plan won’t get you sent to the Leavenworth federal prison.

This benefit cannot be exaggerated.

First, the money you contribute is not treated like income by the Internal Revenue Service. The IRS ignores it when it comes to totting up your tax bill. Then, while the money is sitting inside your account, both that money and everything it earns are tax-sheltered.

Dividends you earn on your ordinary bank account don’t enjoy that tax break. Nor does your regular income. Nor does any profit you make on the sale of stocks and bonds.

If you own a mutual fund that pays you dividends, you’ll typically owe taxes on that income—unless that fund is sitting inside a tax-deferred account like a 401(k) plan.

Best of all, your money remains tax-sheltered as long as it remains cocooned inside your 401(k) account. You probably won’t withdraw it until retirement, so it could remain tax-sheltered for decades.

That means your money and its earnings can continue to grow through compounding without being whittled down by taxes. That’s why money inside a tax-deferred account like your 401(k) grows more than the same money outside a protected account. And it can enjoy that advantage for decades.

However, if you withdraw money before age 59½, generally whatever amount you take out will be subject to income tax plus a 10 percent penalty. Only under certain circumstances can you avoid the tax and penalty. (See Chapter 9.)

Creates Matching Contributions

Would you like a pay raise? That’s what a matching contribution is.

Better yet, it is usually a pay raise that you can give to yourself. Most matches go up when your own contribution does the same.

Typically, you don’t have to ask anyone’s permission. You don’t have to sweat through a job review. (Unless the match hinges on company profitability or your own performance.) It is commonly yours for the taking.

Technically, a matching contribution is bonus pay.

Better yet, it is a bonus that gets the same tax break as your own contribution to your account. It is not taxed as regular income. Further, this bonus—along with its earnings—remains sheltered from taxes until you withdraw it.

This tax-sheltered bonus is unique to 401(k) plans. There is nothing like it in the world of IRAs.

Its purpose is to help your employer encourage you to save and invest for retirement. The fewer retired people who end up on welfare, food stamps, and street corners selling pencils from a tin cup, the better.

A company match is usually triggered by your own investment. But sometimes it depends on your age, years of employment, or how well the company is doing.

One way or the other, 98 percent of 401(k) plans offer some matching contribution, according to benefits consultants Hewitt Associates. Figure 1.1 shows the types of company matches. Most simply give a set amount or percentage of your pay. That’s known as a fixed match. Sometimes there’s an upper limit to a fixed match. For instance, a company may kick in 50 cents for every $1 you contribute, but only up to 5 percent of your pay; you may be allowed to contribute, say, as much as 10 percent of your pay, but you won’t get a match for anything above 5 percent.

FIGURE 1.1 Types of company matches and the percentage of plans that offer each kind. By far the most common type of employer contribution is a fixed match.

Source: Hewitt Associates LLC.

FIGURE 1.2 Fixed company matches come in many sizes. Some are more common than others. Fifty cents for each dollar contributed by an employee is the most widespread.

Source: Hewitt Associates LLC.

A graded match changes, rather than ends, at some specified trigger point.

The size of the employer’s match can differ from company to company. Some give more. Some throw in less.

The most common fixed match is 50 cents for every $1 contributed by the employee. Dollar-for-dollar matches are the next most common. Whatever its size, the company match is virtually a pay raise that you can award to yourself. And often you can get more of it simply by increasing your own contribution.

Sure, more is better. But this is one gift horse whose mouth you should not bother looking into. Even a small match is good. That’s because it is free money. It is a pay raise. And often it is a pay raise you can give to yourself. All you have to do is contribute more of your own money and—presto!—your company must pony up more (unless and until you hit any match cap there is).

Figure 1.2 shows how common each level of employer fixed match is. The table also shows categories within each level.

Figure 1.3 shows how large the most common types of graded matches are. The most widespread graded match is one in which a company antes up $1 for every $1 you contribute up to a specified limit. Then it contributes an additional amount, usually at a lower rate.

As Figure 1.1 illustrates, graded matches account for 21 percent of all the types of company matches. Figure 1.3 lists what percentage of plans offers each type of graded match.

FIGURE 1.3 Some sizes of company graded matches are more widely provided than others.

Source: Hewitt Associates LLC.

More Ways a 401(k) Plan Can Help You

A yearly tax cut . . .

Tax-free growth of your money . . .

A company match . . .

If those were the only advantages conferred by your 401(k) plan, they would be more than good enough reasons for you to sign up and fork over.

But there are additional incentives as well:

• Automatic deposits.

• Flexibility.

• Control.

• Extra perks.

• Portability.

• Protection.

• Best deal.

Automatic Deposits

You don’t have to write a check once a week, once a month, or once a quarter. After you choose how much you want to contribute, money is taken automatically out of your paychecks.

This has numerous advantages. First, it makes contributing pain-free. Money is diverted into your 401(k) account before it ends up in your paycheck or in your pocket. You don’t miss it because you never had it.

Second, it increases the amount of money working for you. It does that by eliminating chances for you to forget to make a deposit on your own. And the more money you have invested, the bigger your nest egg.

Third, it cuts down on paperwork and administrative hassles. You only have to make arrangements once. No muss, no fuss.

Fourth, automatic investing reduces your stress while promoting better investment results. With automatic investing, you will not obsess about every contribution—especially during the stock market’s inevitable rocky periods.

If you had to write a check for every contribution, you would end up playing Hamlet every time the stock market wobbles (to pay or not to pay, that is the question). All you would get out of that, however, is skipped contributions and more gray hairs on your head.

You’d also make the rest of your money less productive.

How? You’d play it “safe” by making more conservative investments. But those investments will lose ground to inflation and grow less than your other investments in the long run. We’ll talk more about the crucial difference between short-term safety and long-term safety, starting in Chapter 16.

Defined Contribution A 401 (k) plan is known in benefits jargon as a defined contribution plan. That’s because the amount you contribute is specified, or “defined.” The size of your eventual benefit is not specified in advance. It depends on such things as how well your investments do and how much money you contribute over what length of time.

In contrast, a traditional pension plan is known as a defined benefits plan because the plan promises to pay you a set amount of money.

For now, what you should bear in mind is that automatic deposits help you stay the course—a more productive, less anxiety-ridden course.

Flexibility

Unlike a conventional pension plan, a 401(k) plan lets you choose the size of your contributions (up to certain limits). That gives you the freedom to boost the size of your nest egg. It gives you more influence over how much money you’ll receive from your account yearly.

Control

You are usually free to select investments from a menu. You can tailor your investments to suit your own financial goals and time frame.

But . . . uh-oh. Select your own investments? If that sounds scary, don’t let it frighten you off.

Chances are your choices are largely—or entirely—mutual funds, other bundled investments, and your own company’s stock. Making good selections basically means choosing something in the right category. It is much easier and simpler than shopping for individual stocks out of the zillions available.

Whether your plan offers only a small number or a wide selection, I explain how to choose your investments in Part Three.

Extra Perks

Your plan may offer additional benefits, such as opportunities to borrow money from your account. (This particular option can come in handy, but you must beware of its long-run cost. See Chapter 4.)

Portability

Another major difference between a traditional pension plan and a 401(k) plan is that your 401(k) account belongs to you. If you leave your job for any reason (except extremely rare cases of criminal activity), you can take the portion of your money in which you are vested. You are always fully vested (100 percent ownership) in your own contributions, right from the first day. You generally gain ownership of your company’s matching contributions either when you sign up or according to a timetable spelled out by your plan.

Protection

Life can bring unexpected—and unwanted—twists and turns. So it’s helpful that assets in a 401(k) account are generally shielded by federal law from any creditors you may have. Your IRA assets enjoy federal protection only if you declare bankruptcy. Some, but not all, states also declare IRA assets beyond the reach of creditors.

What if your employer tumbles into bankruptcy? All your 401(k) money stays safely yours. That’s not the case with traditional pension plans. Even though the Pension Benefit Guaranty Corporation can step in when a business goes bust, workers may never get the full value of their pension. Further, if your employer folds and stops sponsoring your plan, any company match you were not already fully vested in automatically becomes 100 percent yours.

Meanwhile, the money that’s been in your account all along is still safe, too. The account assets are typically in the custody of outside, third-party financial institutions.

Best Deal

A 401(k) plan is routinely a better deal than other comparable retirement plans. If you take full advantage of its contribution and investment opportunities, no other plan gives you as rich a chance to reduce taxes and build up a nest egg.

Even the much-ballyhooed Roth IRA can’t compare. A 401(k) plan’s higher contribution ceiling lets you accumulate much more money. And, even if you contribute the same amount of money annually you’re better off with a 401(k) plan. By the time you retire and start to withdraw funds, a 401(k) plan will put more after-tax take-home money into your pocket than a Roth IRA if, like most people, your tax bracket goes down after retirement.

Heck, if it will make you feel better, after retirement you can put your money into a legal Swiss bank account.

Chapter 2

Time and Money: Your Plan’s Wealth-Building Weapons

The bedrock principle of 401(k) plans is very simple: Time is money.

But the reason so many people are puzzled by Wall Street is that time is not always worth the same amount of money. For people on Main Street, it is too hard to predict which investments will make money grow quickest.

Unsure about what to do, people often do the very worst thing: nothing.

You might as well rip up hundred-dollar bills.

In truth, time is worth a lot of money. That’s why it is so important to join your plan.

“Time is probably the biggest ally that people have,” says David Wray, president of the Profit Sharing/401(k) Council of America.

Give Your Money Time to Grow

One reason time matters so much is something learned in the previous chapter: Your plan adds value to your money several ways.

1. It cuts your tax bill every year you contribute to a traditional account in your plan. That’s nice by itself. It has an additional benefit if it persuades you that you can afford to jack up your contributions.

2. Your investment earnings grow more because the IRS ignores them.

3. Your company probably matches your contribution with one of its own to your account.

Time is the tool that enables you to earn more wealth with those sources of money.

Here’s how it works: Your investment earnings accumulate their own earnings. This monetary snowball may start out small. But it builds on itself.

Look what happens when you put a dollar bill on the table and then place a dime next to it. It may not seem like you’ve added much money. Still, you only need to increase the total by 10 percent eight times before you more than double the cash.

Make that dollar bill into a $1,000 investment, and with 10 percent yearly growth it is transformed into $2,000 in less than eight years.

Money snowballing like this is called compounding. It’s no accident that everyone in the financial industry refers to it as the power of compounding.

Figure 2.1 illustrates this financial growth process for three hypothetical investors. Each sticks to a very different strategy.

FIGURE 2.1 Time is money: the power of compounding. The amount of time you invest can influence the eventual size of your nest egg even more than the amount of money you invest.

Investor #1 (whom we’ll call John) starts at age 25 and socks away $2,000 a year for 10 years. From age 35 through retirement at age 65 John does not invest any more money. But his money earns, say, 10 percent annually for the entire 40 years. By retirement, he has invested only $20,000 from his own pocket. But his account has grown to $611,817.

Investor #2 (whom we’ll call Susan) also invests $2,000 a year, earning the same 10 percent as John. But Susan doesn’t start until age 35 (the same year John stops making new contributions). Also unlike John, Susan continues to invest money yearly until retirement. So by age 65 she has contributed $2,000 annually for 30 years, or a total of $60,000. Yet her nest egg at retirement is only $361,887.

The outcome seems to defy common sense. But the arithmetic behind it is beyond doubt. Even though Susan shells out three times more money than John, she ends up with much less—all because she started later and gave her money less time to compound.

Compounding Compounding is what goes on when you earn money on your initial investment as well as on the new earnings.

With a $1,000 investment that earns 10 percent annually, for example, you’ll have $11,00 at the end of one year. During the next year, both your original $1,000 and the new $100 earn another 10 percent. So by the close of year No. 2 your investment will be worth $1,210.

Some investments compound (or earn more money) at set intervals. For example, a bank may pay compound interest daily, weekly, monthly, or at some other interval of time.

John’s 10-year head start makes the difference. Time is indeed money.

The virtue of starting early and then sticking to an investment game plan is illustrated by a third investor, Pat, who starts at age 25, the same time as John, but diligently continues to invest $2,000 annually for 40 years. Pat earns 10 percent, just like the others. But by putting the most time as well as the most money to work, Pat naturally accumulates the largest retirement account: a comfy $973,704.

A Pricey Problem to Avoid: Making Up for Lost Time

Time is money when you waste it, too.

Figure 2.2 shows exactly how painfully expensive Susan would find it to catch up to John. To make up for John’s 10-year head start, she would have to invest much more cash than John does to build the same size nest egg by age 65.

Susan would have to invest $3,381.26 every year for 30 years to accumulate the same $611,817, all other things being equal. John invested only $2,000 a year, and that was only during the 10 years when John actually paid into his account.

Susan must dip into her paycheck an extra 20 years to catch up to John. Meanwhile, John contributes zero during those decades!

All tolled, Susan must invest more each year for 30 years. John pilfers from his wallet for only 10 years.

So, by the time she reaches retirement, Susan would have to pay $101,438 out of pocket—more than five times John’s modest $20,000—to make up for lost time.

Another way to look at this: It costs Susan more than five times what John must pay to buy the same retirement nest egg.

To compensate for her delay of a measly decade early in her work career, Susan must pay an extra $81,438. That’s how much compounded earnings she lost. Now it is her penalty fee.

Think about it:

• Spending five times as much cash to buy the same retirement fund.

• Spending more money three times longer.

FIGURE 2.2 Making up for lost time: Because she started her 401(k) contributions a decade after her fellow worker John, Susan must invest more than five times as much money to build the same size retirement account by age 65.

• Spending four-fifths of your cash outlay to make up for lost compound earnings—something you could have had for free.

The price for procrastination is steep.

So don’t postpone enrolling just because you’re afraid of making the wrong investments. Put your money to work. Enroll now if you haven’t. And increase your contribution if you can. Take advantage of time.

Tax Deferral: How It Makes Your Money Grow Faster

Okay, so time is money.

Tax deferral is a process that lets you speed up time inside your account.

If you had the same investments outside a 401(k) plan, in an ordinary brokerage account, you’d have to pay taxes on earnings every year. In your 401(k) account you get to keep that money instead of paying it in taxes. And as long as it stays in your account, it can rack up more earnings.

It’s like having more money—because it is