The Bogleheads' Guide to Retirement Planning (16 page)

The 401(k) packet you receive from your employer when you start a new job may urge you to roll over your existing IRA or the 401(k) held with your previous employer into your new 401(k). This is rarely a good idea. With an IRA at a low-cost company like Vanguard, you can hold the Total Stock Market Fund for an expense ratio of 0.15 percent, or as low as 0.07 percent if you invest $100,000. Very few 401(k) plans offer such low-cost funds, so it is rarely a good idea to transfer money into them.

The best-designed 401(k) plans leverage the latest behavioral economics research to nudge employees into making good choices. Unfortunately, well-designed plans are the exception because a vast majority of 401(k) plans today provide employees with a list of extremely confusing investment options. Worse, the funds selected by 401(k) providers tend to highlight past performance numbers, which are not at all predictive of future returns.

The Pensions Protection Act of 2006 encourages the use of what are called automatic 401(k) or autopilot 401(k) plans. This feature tries to leverage the inertia that many employees feel in making a saving decision. The strategy is to use the inertia in favor of saving, rather than against it.

In an automatic 401(k), new employees are automatically enrolled to invest a portion (often 3 percent or more) of their salaries into their 401(k). When they receive a raise or cost-of-living adjustment, some or all of the increase is automatically added to their 401(k) contribution rather than to their take-home paycheck. That way, employees feel like they are making the same or slightly higher income while their 401(k) contributions see a significant increase. Automatic 401(k) plans normally select a good default investment choice, such as a low-cost, age-appropriate target date fund.

You can withdraw your 401(k) holdings without penalty at age 59½ or at age 55 if you leave your employer. Ordinary income taxes are due on all withdrawals.

One advantage of a 401(k) over an IRA is your ability to take a loan from your 401(k) account for up to $50,000 and five years. Although this kind of loan is not recommended, it is superior to borrowing at credit card interest rates. If you do not repay the loan on schedule, or if you leave your employer prior to repaying the entire loan, it converts to an early withdrawal. Early withdrawals from a 401(k) incur a 10 percent penalty in addition to the ordinary income taxes due.

Finally, employees have the option to opt out at any time. The idea of an automatic 401(k) is to nudge employees toward good behavior rather than force them. The opt-out makes employees more comfortable about accepting the automatic increases in their savings rate.

The basic problem with 401(k) plans is that the fund menu is selected by the employer, who often does an extraordinarily bad job. A whole industry of consultants is on hand to recommend expensive, actively traded mutual funds for the plans, often based on what has performed well recently. Many 401(k) plans offer no index funds at all or just a single, overpriced fund tracking the S&P 500. Expense ratios in many 401(k) choices are obscenely high. One to 2 percent is common, and some plans charge 3 percent or more, when all fees are taken into account. By contrast, Vanguard index funds are available for 0.2 percent or less, either through an IRA or through a reasonably administered 401(k) plan. The difference might not seem like much, but compounded over 20 years, this means that hundreds of thousands of dollars that should be available for your retirement instead went to overpriced fund companies.

It can be incredibly difficult to find out how high the fees are that you’re actually paying. Although many plans provide the ticker symbols for their funds, they don’t always list the additional fees (such as asset management fees) that they add on top of the fund charges. Many plans offer proprietary funds that have no ticker symbol, making them impossible to track through publicly available information. Your company’s human resources staff has a legal obligation to provide you with information on your plan options, but all too often, they are not well informed and are overtaxed with other benefit issues.

Finally, most 401(k) plans are still designed with an overwhelming number of options. The default contribution level is generally zero, and the default fund selection is generally a money market account that probably won’t even keep up with inflation. The automatic 401(k) has barely begun to be implemented.

Some of the very worst plans seem to be 403(b) plans for teachers. For historic and completely obsolete reasons, these plans put funds inside expensive annuities. Since the 403(b) is already a tax-deferred account, adding an annuity wrapper adds cost without providing any additional tax-deferral value. Unfortunately, a large number of school districts have locked their teachers into selecting only between high-cost annuity providers.

The dominant 403(b) provider to colleges and universities, TIAA-CREF, is somewhat of an exception. The CREF mutual funds are a much better value than the high-priced annuities found elsewhere. Most important, TIAA-CREF does not lock in employees with surrender fees. However, their expense ratios are still generally two to three times what Vanguard offers for comparable funds. The web site
http://403bwise.com
offers detailed information on 403(b) plans, including how to lobby your school board for better plan options.

The 457 plans are a way for government and nonprofit employers to provide additional tax-deferred retirement opportunities, generally on top of an existing 401(k) or 403(b) plan. They allow early withdrawal without penalty but do not allow loans. In general, you should first contribute the maximum to your 401(k) and IRA. If you have more savings available and you qualify for a 457 plan offered by your employer, it is a great alternative to saving in a taxable account. The maximum allowable contribution is $16,500, which is in addition to the $16,500 that can be contributed to a 401(k) or 403(b).

Many 457 plans have problems similar to the 401(k) and 403(b) issues. Specifically, it can be difficult to find out how high the fees are that you’re actually paying, the investment choices are poor or limited, and some plans put funds inside expensive annuities. Many 401(k) plans offer no index funds or just one high-cost fund that tracks the S&P 500. If you find yourself in a bad plan, contact the trustees and state your discontent.

The federal thrift savings plan, or TSP, is a retirement savings plan for civilians who are, or previously were, employed by the U.S. government and for members of the uniformed services. The TSP encompasses many millions of investors and has substantial assets.

The TSP is a defined contribution plan administered by the Federal Retirement Thrift Investment Board. In most ways, the TSP closely resembles the dynamics of 401(k) plans. The retirement assets derived from a TSP account depend on how much has been contributed to the account (both by the employee and, if applicable, his or her agency) during the account holder’s working years and the earnings on those contributions. The government makes automatic and matching contributions for certain Federal Employee Retirement System (FERS) civilian employees, based on the employee’s contributions. The FERS employees receive two different types of contributions: automatic contributions and matching contributions. The government automatically contributes 1 percent of basic pay to the TSP for each employee. In addition, for employees contributing their own money to the plan, the government contributes matching funds for the first 5 percent of pay each pay period. Contributions are matched dollar for dollar on the first 3 percent of pay and 50 cents on the dollar for the next 2 percent of pay.

Employees under the CSRS (Civil Service Retirement System) may participate in the TSP but are not eligible for matching contributions. Military members are generally not eligible for matching contributions.

The government did nearly everything right in developing this offering. They provide indexed funds covering domestic stocks (large and small), international stocks, and bonds. They have target retirement offerings that they call lifecycle (L) funds. These funds let investors make a single selection that automatically rebalances and adjusts their holdings to become more conservative over time. But most important, the government leveraged the fact that they have the largest retirement plan in the world to negotiate the very lowest fees anywhere. The fees for TSP funds are 0.015 percent; some 401(k) plans make their employees pay 200 times more. The fees are the lowest available to any retail investor and actually lower than what many huge institutions pay to invest their money.

One option that is beginning to appear in some plans is a Roth 401(k). Like the difference between a traditional IRA and a Roth IRA, a Roth 401(k) lets you invest after-tax money. One big advantage is that $16,500 in after-tax money is equivalent to $22,000 in pretax money if you’re in the 25 percent tax bracket. So, a Roth 401(k) lets you save much more in a tax-advantaged account. Roth 401(k)s are particularly well suited to younger workers who are currently in a low tax bracket but expect to be in a higher bracket at retirement.

However, it’s impossible to know what marginal tax rates will be in retirement, since Congress has consistently changed the laws every few years. Also, a Roth 401(k) is taxed at your (high) marginal rate today, whereas a traditional 401(k) will be taxed at your (lower) average rate when you retire. Since there are so many unknowns, one reasonable approach is to split your savings 50/50 between a traditional IRA and a Roth 401(k). However, if you are already in a higher tax bracket, you should probably skip the Roth 401(k).

Also, if you are close to the Roth IRA cutoff limits, the traditional 401(k) may be a better option. The Roth 401(k) does not reduce your taxable income, possibly pushing you over the limits and preventing Roth IRA contributions. By contributing to the traditional 401(k), you reduce your taxable income.

A profit-sharing plan is an incentive-based compensation program designed to reward employees by giving them a percentage of the company’s profits. It can be a company’s only retirement plan, or it can be offered in addition to a 401(k) or other plan. Some plans let you manage your own account, but most select the investments for you.

You have access to the money after a fixed number of years or when you leave employment. Both the contributions and the returns you earn are tax-deferred until you withdraw the money. When you leave employment, you can roll over the money to an IRA to preserve the tax-deferred status of the money.

The big advantage of profit-sharing plans is that they provide a way for a company to make substantial tax-advantaged payments to employees when the business is doing well. For 2009, these contributions can be as high as $49,000 or 25 percent of your salary, whichever is lower.

If you are able to manage the money in your account, treat it like a 401(k) plan and select the best (or least bad) investment choice. If your employer invests the money for you, you have no control but should still understand how your employer invests the money and take it into account when building the portfolio that you control.

An age-based profit-sharing plan uses both age and compensation as a basis for allocating employer contributions among plan participants. All of the basic requirements that apply to profit-sharing plans also apply to age-based plans. This type of plan typically has a contribution formula that gives the employer flexibility over the amount of the contribution to be made each year. Since age is a primary factor in the contribution amount, age-based plans tend to favor older employees who have fewer years to accumulate assets for retirement.

A money purchase pension plan is a defined contribution plan where your employer’s contributions are mandatory. It works like a profit-sharing plan, except that your employer can owe a penalty tax if it doesn’t make the required contribution. Like other defined contribution plans, the amount of retirement benefits for employees is based on the amount in the participant’s account at the time of retirement.

Employers normally must make contributions to a money purchase pension plan regardless of profitability, although there are generally no unfavorable consequences to the employer if contributions stop completely. However, if the employer desires to maintain a money purchase pension plan in the future and start making contributions again, failure to make a contribution continuously could result in the imposition of a penalty tax on the years when contributions were not made. Consult your tax advisor if you have questions about an existing plan.

A target benefit plan is a defined contribution plan that has similarities to a defined benefit plan. The target benefit is the equivalent of a pension in a defined benefit plan. Your employer makes annual contributions based on a formula that would be sufficient to provide the target benefit, assuming an interest rate and other actuarial inputs.

Unlike defined benefit plans, money allocated to your target benefit plan is not pooled among employees. It is yours. However, if the assumptions used provide more or less money than needed for the target benefit, the result is that you receive more or less than the target benefit. So, you, not your employer, bear the consequences if your investments do not perform as well as expected.

Target benefit plans are similar to money purchase pension plans, except rather than a fixed amount based on your compensation, a target benefit plan provides contributions with the goal of providing a fixed benefit. This favors older employees, who have less time to have their benefits funded.