By FPA member Scott M. Kahan, CFP®
Last Updated: September 26, 2011
A company sponsored retirement plan is one of the best benefits your employer can offer you; but in order to realize the greatest success with this benefit, you need to play an active role. There are a number of common mistakes to avoid and steps you can take that will help put you well on your way to making the most of what your plan has to offer.
Mistake: Not contributing.
The reasons many do not contribute are numerous: cannot afford it, too overwhelming to review the plan and pick choices, or just forgetting to set it up. The reality is you cannot afford to pass up the savings opportunities available with a company sponsored retirement plan. Each day you are not contributing is a day missed in savings.
Contributions to company sponsored retirement plans, whether a 401(k) or 403(b), are tax deferred; this means funds are taken out of your income before taxes whereby reducing your current taxable income. You only pay taxes on contributions and earnings when the money is withdrawn and it is likely that you are at a lower tax base. For instance, if you make $50,000 a year and contribute $1,000 a year to your plan, your income will be taxed on $49,000 not the $50,000. So, in a 25 percent tax bracket, every $1,000 you contribute before taxes will save you $250 in taxes. If you are in a state that has high taxes, the savings can even be more.
Not contributing also means you are likely not taking advantage of the company match that many companies offer — who wants to walk away from free money! Down the road, the company match could mean all the difference to your retirement savings.
Solution: Even a little adds up! If a plan is offered, take advantage of it. Even if you can’t fund much, funding something gets you started and you can always increase the amount later. If you breakdown what a $1,000 contribution a year is on a bi-weekly pay schedule, that’s only a difference of $38 in take home pay per pay period — think of that as six lattés. Finally, if you feel like getting started is too overwhelming, then find out if your company offers access to a financial professional as part of set up or use the online tools many plans offer to help you walk through it.
Mistake: Paying too much or too little attention to the account.
The good news is that you started funding the plan, but now what? Like any investment, company sponsored retirement plans should not be ignored, but over-managing can be just as dangerous.
When you initially signed up for the plan, maybe you chose the money market to get started and never changed it, or you chose the S&P 500 Fund for all the money, but now you are older and are invested too aggressively. Sometimes, the plan will change fund options and employees just go along with the changes but never investigate if the new funds offered are actually what are best for them. The fact is that circumstances in life change and, as you age, allocations and risk tolerances should be adjusted. So it is important to not take a “set-it and forget-it” approach.
On the flip-side, over-managing can lead to problems as well. Because of the nature of how investing into a 401(k) or 403(b) is set up, you are allowed to take advantage of a dollar cost averaging approach. This means that every pay period, the same amount of money goes into the same funds. So when the prices drop, you buy more shares and when prices rise, you buy fewer shares. If you over manage by changing funds frequently due to market panics, then you lose the dollar cost averaging advantage and possibly find yourself buying high and selling low, a strategy designed to fail. Assuming that you are not touching the money in this account for a number of years, a better strategy is to leave things in place during the volatility.
Solution: Review your accounts on a semi-annual basis. Taking a more systematic approach will allow you to re-allocate based your risk tolerance, timeline and model that is best for you. By doing this, you will be forcing yourself to sell sectors that have appreciated and buy others that have underperformed. In other words, buy low and sell high — a winning strategy over the long run. Finally, do not be afraid to turn to a professional for help when you need to, especially, if you are already working with a financial planner as he or she can help you review your plan options and choose reallocations when necessary.
Mistake: Holding too much company stock.
Some 401(k) plans offer the ability to buy company stock within the confines of the plan and this may be in addition to a stock purchase plan that is offered outside the 401(k) plan. It is great that you have confidence in the company you work for and want to buy more stock, but if you are holding too much stock and the company suffers financial problems, then the stock price inevitably falls thereby causing your retirement plan balance to be at risk. Remembering Enron and how its employees retirement plans suffered will quickly remind you of how this can go bad.
Solution: Limit company stock to an overall 10 percent of total retirement portfolio. Diversification is important and by owning too much of one investment, you are adding unneeded risk to your portfolio.
Mistake: Leaving your account behind.
When you leave a company at or before retirement, do not forget about the retirement assets you have accrued in your 401(k) or 403(b) accounts. The money you have put into that account is yours and depending upon the company’s vesting schedule, so is your earned company match. It is also important to realize that leaving the company may not be the only way you are leaving your account behind — an unexpected death without beneficiaries named on your account could mean the plan money gets distributed to your estate and can possibly incur unwanted tax implications.
Solution: Know what your distribution choices are. It is recommended that when you leave a company you rollover the funds to an Individual Retirement Account (IRA) or a plan at your new job (if allowed). Often the best option is the IRA rollover. Rolling over the account, gives you complete investment flexibility as you are no longer limited to the choices offered by your previous employer.
And, if you do have company stock in your plan, you can either roll-it-over as well or use a strategy known as Net Unrealized Appreciation (NUA). With NUA, you pay tax on the cost basis of the stock. All gains on the stock are then taxed at long-term capital gain rates when you sell it. So the stock is no longer tax deferred, but the income tax rates are lower based on the current tax laws. This is a complicated strategy and needs to be reviewed carefully to see if it is a viable option for you.
Lastly, name your beneficiaries and keep these updated. Thus, your heirs will receive the best tax advantages to the money you are leaving behind.
Participating and managing your company sponsored retirement plan does not have to be complicated or overwhelming. Always consider the options carefully when investing your money. Do not panic during market fluctuations and always keep in mind, these are long-term investments!
FPA member Scott M. Kahan, CFP®, is president and founder of Financial Asset Management Corp. in New York City.