Tax Moves to Make Now to Lessen the Pain Come April 2012

By Carla Fried

Between now and the end of the year you can make some tactical money moves that will save you some serious money next Spring. Consider these year-end moves that can trigger a smaller tax bill come next April 15th:

 

• Sell a losing investment. Time for some classic lemonade making. If you have an investment-stock, fund, ETF etc-that has lost value amid the markets big swings this year, you might be able to reduce your tax bill by selling it for a loss. Sell an investment at a loss and it can it can be used to offset any gains. An investment held less than on year is considered a short-term loss; holdings of more than one year are considered long-term. Short-term losses can be used to offset short-term gains, long-term losses are applied to offset long-term gains. (Remember, short-term gains are taxed as ordinary income. Long-term gains are taxed at a maximum rate of 15%.) If you don’t have any gains to offset losses, you can use $3,000 a year in losses to offset ordinary income tax. If your loss is more than $3,000, don’t worry. You can keep claiming the loss as a way to reduce your taxable income in subsequent years until you’ve accounted for the entire loss. It’s just that you have to do it in $3,000 annual increments.

• Note: If you want to sell an investment at a loss to claim the tax break and then repurchase it, be careful. You need to wait 30 calendar days to buy the exact same investment. This is what is known as the wash-sale rule. But you could buy a similar investment, just not the identical investment. So for example, if you sell Exxon Mobil you could buy Chevron immediately. It’s just that you need to wait 30 calendar days before repurchasing Exxon Mobil.

• Accelerate Mortgage and Property Tax Payments. If you’re looking for ways to generate more tax deductions, consider paying some of your 2012 housing bills before Jan. 1. For example, if you make your January 2012 mortgage payment in December 2011 you can claim the interest portion as part of your 2011 mortgage interest deduction. Same goes with any property tax you prepay. (Of course, this only works if you choose to itemize your deductions, rather than claiming the standard deduction.)

• Get Tactical with Medical Expenses. If you’ve shelled out more than usual for medical expenses this year, do a quick calculation to see if your total out of pocket costs might be near 7.5% of your adjusted gross income for the year. Any medical costs above the 7.5% threshold can be claimed as a deduction. So if you’re close you might consider pushing any elective procedures you anticipate having in 2012 into this calendar year.

• Think Charitably. Charitable donations you make by year end can be claimed as itemized deductions. That’s a win-win; helping causes you believe in and getting a tax break as well. If the value of any donation is $250 or more, make sure you file away a copy of the receipt/recognition of your donation.

 

 

 

The Buy v. Rent Conundrum

By Carla Fried

It turns out that plenty of Americans are still sold on the American Dream. In Fannie Mae’s latest survey, 62% of folks said that if they were planning to move right now they would buy, rather than rent. Moreover, 69% of the same survey respondents believe that right now is a good time to buy a home. Indeed it is. With mortgage rates at historic lows and prices having seriously deflated since the bursting of a bubble, prospective buyers face an enticing market. The economic forecasting firm FiServ notes that the national median home price is now back to within 5% of its 2003 level.

From a straight-up cost perspective, buying can in fact be the better deal these days. While home prices have fallen, rents haven’t. Real estate forecasting firm Reis, Inc. predicts 2011 apartment rental rates will rise 6% or more in major markets including San Jose, Washington D.C. and New York City, and foresees average apartment rental rates bumping up another 3% in 2012. According to real estate research firm Trulia, buying beats renting in more than 70% of the metro markets it tracks. (That link to Trulia takes you to a way-cool interactive map that; it’s well worth taking a spin.)

But let’s face it, pulling the trigger is anything but easy these days. For starters, there’s the not-so-small worry that prices could head even lower. And then there’s the high-jump challenge of getting approved for a loan.

To help you wade through your options, think through these factors:

1. Am I going to stay put for at least five to seven years? Even if prices are stabilizing in your area, you’re not likely to see big price gains in the next few years. In a recent survey of more than 100 housing economists, the general consensus was for prices to inch along at a 1.1% annualized rate gain through 2015. That’s actually good news, compared to the losses since 2006, but it also means you can’t expect to have strong appreciation to cover the costs of eventually selling. Remember, there’s going to be the agent’s fee to sell, which typically is 5% to 6%, combined with moving costs etc. So you only want to be buying today if you intend to stay in that home for a good chunk of time. There’s a terrific free rent v. buy calculator at the New York Times that allows you to play with all sorts of variables to get a sense of what might make the most sense given your financial situation and what you expect to happen with locak housing (and rental) prices.
2. Will I pass muster with a lender? Let’s just say lenders have swung to the other end of the pendulum the past few years. After spending the bubble years handing out mortgages to just about anybody who wanted one, now you must actually prove you qualify. And those qualifying standards have gotten much tougher. To have a shot at a great interest rate you’ll need a FICO credit score of at least 720-740 and be able to make a down payment of at least 10%, though 20% is what is going to give you the best shot at getting a conventional mortgage. If that down payment hurdle seems impossible high, you should definitely look into an FHA-insured loan; most lenders offer ‘em. Because of the government backing, the lending standards for these loans are way more lenient. Many lenders will consider an FHA-insured loan if your FICO credit score is at least 660 or so, and the down payment can be as low as 3.5%. Just keep in mind that with the FHA option you pay an upfront 1% fee for the insurance and an ongoing annual charge of 1.1% (1.15% if your down payment is less than 5%) until you have at least 22 percent equity in the home.
3. What’s my all-in ownership cost? Just because you can afford the $1,500 rent does not mean you can afford a home with a $1,500 base mortgage. Make sure you factor in the cost of property tax; yes it’s deductible if you file an itemized return, but it’s still a hefty annual charge that can be 1.5% or more of your home’s value. And then there’s home insurance; a solid policy—you want to ask for extended replacement cost coverage; do not settle for actual cash value-is going to be more expensive than any renter’s policy. And let’s not forget all the maintenance costs once you settle into your own place. Get estimate for all those costs-ask friends what they pay. This exercise isn’t to talk you out of buying, but rather to help you buy smart: you might find you want to lower your shopping price point a little bit to make sure your total all-in monthly costs won’t be a stress on your finances.

How to Bring Down the Cost of Your Health Insurance

By Carla Fried

Fall is the official season for benefits enrollment at work. And once again you could be facing the not-so-fun news that your health insurance premium will be heading higher next year. A national survey says average health plan costs will rise by more than 7 percent in 2012, and more than half of the surveyed firms say they expect to hit up workers to shoulder some of that increase.

If that’s making your blood pressure rise, perhaps it’s time to take a look at a High Deductible Health Plan. Many employers now offer these plans; it’s anticipated that by 2013 more than 75 percent of businesses will have it in their lineup. If you and your family are in good health, an HDHP can be a smart way to lower your health insurance premium costs. Moreover, once you’re enrolled in a high-deductible plan you’re eligible to contribute to a health savings account (HSA) with pre-tax dollars deducted from your salary.

Money you set aside in your HSA can be used to pay for most out-of-pocket health care costs, including your deductible, co-payments and any other standard medical costs. Using pre-tax dollars to pay your out of pocket costs is another smart money saving move.

In a healthy year when you don’t need to tap the account, you just leave the money in your HSA. In fact, you can leave the money growing for decades if you want. In retirement, any withdrawals for approved health care costs will be 100% tax free. And in a neat twist, your HSA can also moonlight as an ancillary IRA as well. You can withdraw money from your HSA in retirement and use it for anything-a vacation, a car repair, you name it-and there is no penalty, though just like a traditional IRA you will owe income tax on withdrawal amounts that are not used for health-care expenses.

Here’s how to think through whether a high-deductible plan might be a good move for you in 2012:

• Can you handle the high deductible? In 2011, for a plan to be considered “high deductible” it must impose a minimum deductible of at least $1,200 for individuals and $2,400 for families. (The rules for 2012 will be out in October; ask HR if the limits have been raised.) These plans work best for healthy employees who have a good chance of not coming close to hitting their deductible. But you still want to make sure that in the event you did have high medical expenses you could handle the high deductible.

• Can you handle the annual out-of-pocket maximum? In 2011 the most you would have to pay is $11,900 for a family and $5,950 for an individual. Those aren’t exactly small sums. So think through how you could handle the “worst case” scenario.

So with those two big hurdles, you might be wondering what’s the advantage. Well, for starters, your annual share of the premium will be a lot lower than with a traditional plan. You’re trading off that cost for assuming more cost if you in fact do need care. And a powerful kicker is the aforementioned HSA account offered by many plans. (Some employers opt instead for what is called a Health Reimbursement Account-HRA-in which your company sets aside money in an account for you to use to pay medical bills.) In 2011 you could set aside as much as $6,050 in an HSA account for a family plan, or $3,050 for individual coverage. (Again, just in with HR for the 2012 limits.)

As mentioned above, money you contribute to your HSA can be rolled over into subsequent years. There’s no use-it-or-lose-it provision as with your flexible spending account. (Note: HRAs work differently; it’s up to your employer to set the ground rules for what happens with unspent funds from year to year.) That’s a nice way to set aside some money for future health care expenses. Or best case scenario, you don’t need the money now, and can tap it – tax free – to cover medical costs in retirement.

Ready to Invest…But Not Really?

By Jacquette Timmons

There is no question that investing in the stock market is one of the best ways to create wealth. But when the stock market goes down 600 points one day; rebounds 400 points the next day; and then retreats again by more than 500 points the very next day, it is no wonder beginner investors are squeamish as they try to figure out what do, when, and how. Heck, even the pros have a hard time stomaching the drastic swings – aka volatility – even though the market’s ups and downs are part of its nature.

However, there is a way to "practice" investing before you actually invest. It is called "virtual" investing, and there are many benefits to having a virtual stock portfolio. For starters, you get to see if how you think you’ll react is how you actually react when you gain or lose money. This is a wonderful way to help manage your expectations. Second, it can satisfy your curiosity about the stocks you have your eye on - on both an individual basis as well as in combination with your other portfolio holdings. Finally, managing a “practice” portfolio is a great way to get objective confirmation as to whether or not you behave like an investor…or a trader.

Here are two ways to use a practice portfolio to prepare for actual investing:

• Open a virtual account with companies like WeSeed or the Wall Street Journal’s Virtual Stock Exchange – both are free to join, use fake cash, and operate in a virtual trading environment with real-time stock exchange conditions.

- or -

• Create a virtual portfolio using Yahoo.com and an excel spreadsheet to track losses and gains. Ironically, "practice" investing is not only good for beginners; it is an excellent way for more experienced do-it-yourselfers to "test" the waters before committing to particular stock or portfolio of stocks. But there's one word of caution: Don’t do anything in your virtual portfolio that you wouldn't do if you were using real cash. If you do, you mitigate the benefits that come from getting ready for the real thing.

Roth or Traditional IRA: How to Make the Call

By Carla Fried

It may not have the caché of boxers or briefs, but in retirement circles one of the big questions is whether you should invest in a Roth IRA or a Traditional IRA. And if you happen to work for one of the few companies that offers a Roth 401(k) option you’ve got to face this dilemma of which way to go with your 401(k) as well.

The math is pretty easy if you are young and haven’t yet reached your peak earnings. If you’re not yet in a high tax bracket, there’s not tremendous value in using a Traditional IRA or 401(k). Your contributions do indeed reduce the amount of taxable income you have for the year, but if you’re in a low tax bracket, then that’s not exactly a huge deal. I’d put a vote in for going with the Roth. You forego that upfront tax break on your contribution –all money you pile into a Roth is done with after-tax dollars –but oh what you pick up on the back end of the deal: Every dollar you withdraw from a traditional IRA or 401(k) is taxed at your ordinary income tax rate. Capital gains rates do not apply to IRA and 401(k) investments. But with a Roth you can withdraw every penny tax free in retirement. Free as in zero tax.

Now if you’re already in a high federal tax bracket and/or you’ve got a large state income tax to deal with, a Traditional IRA can still make a ton of sense; reducing your taxable income right now has plenty of value to you. That said, having some retirement income that will be yours to tap free of owing any tax is alluring as well. A popular approach used by many financial advisors these days is to recommend you have both types of retirement accounts. Think of it as tax diversification: you get the benefits of both the Traditional (up front tax break) and the Roth (no tax on withdrawals!). It's also a smart way to hedge your retirement portfolio against whatever may happen to our tax code in the coming years and decades. By having money in both types of retirement accounts you can rest a little easier that you won’t get whipsawed by any unforeseen policy change that impacts your tax bill.

Is an Adjustable-Rate Loan Too Good to Pass Up?

By Carla Fried

If you're contemplating buying a home, or refinancing, mortgage rates are certainly working in your favor. Cheap doesn't seem sufficient to describe today's 4.6 rate on a 30-year fixed rate loan. At the risk of showing my age, I remember when the 30-year fixed was above 10 percent. (1990, okay?) And just 10 years ago we were staring at 7 percent and thought that was a pretty good deal as well. So 4.6 percent is ridiculously low.

But it's not as low as you can go. Adjustable rate mortgages are of course, even less expensive. A 5/1 ARM in which the interest rate stays put for five years before it can be adjusted has an initial interest rate of 3.2 percent. Factor in the value of your mortgage interest deduction and your effective rate could be close to 2 percent. That's hard to pass up, and over the past year, ARMS have become more popular.

But all the same, if I were in the market right now I would not flinch for a second and stick with the 30-year mortgage. For a couple of reasons:

• I’m picky about where I want to take on risk. We can all do the math on the savings that come with opting for the 5/1 ARM over the 30-year, but with that lower rate I'd have to take on the risk of what happens after five years. Most ARMS can adjust up to 2 percentage points a year, with a maximum increase of 6 percentage points. So worst case scenario is that if the general trend of interest rates heads up over time, I could be stuck with a 9 percent interest rate. I have to take risk in my 401(k) to have a chance at inflation-beating gains that stocks deliver. I don't care to take risk in my home as well.

• I am not big on assumptions. Ok, so it's absolutely true that I could refinance out of my ARM if in fact year five rolls around and interest rates are indeed higher. But that depends on a few faulty assumptions. If ARM rates are higher, fixed rates will be higher too. Just saying. And if we've learned one thing as the real estate bubble has deflated, is that it's not exactly a given that you will be able to refinance. Maybe you won’t have built up enough equity. Maybe lending standards will have gotten tougher (scary thought, eh, given where they are today) or maybe your financial situation has changed-new job, layoff, moving to part time-so you might not qualify based on your current earnings. Just because you want to refinance doesn’t mean you can assume you will be able to refinance.

• I have no intention to move within 5-7 years. A 5/1 ARM begins to make a little more sense if you are sure you will move before the ARM hits its first potential adjustment. I'm hoping to stay put for a while, so count me out. And if you're going to move in a few years, I wonder if you should be buying in the first place. After paying the agent's fee and accounting for other moving costs you can easily be looking at forking over 8 percent to 10 percent of the sale price. Are you sure you're going to get at least that much appreciation during the time you own, to offset those costs? The worst of the price declines is over, but we could still be in a for a few years of stagnated prices as some areas have a big backlog of foreclosed and distressed homes to sell. Banking on 10 percent appreciation might be pushing it a bit.

• We're at a pivot point in the interest rate cycle. We don’t know when interest rates will start to rise; but we do know they are at historical lows. Long-term the trend is for interest rates to rise. If you're in an ARM that spells higher payments down the road. Me, I'm just fine settling for a slightly higher fixed rate loan that will never move a penny on me. Sure, 3.2 percent is great. But so too is a 4.6 percent rate that I don't have to worry about.

How Your Kid’s Summer Job can Jumpstart Retirement Savings

Carla Fried

 

Okay, I know it sounds absolutely crazy to suggest a teenager or college student should be thinking of retirement. But if your child has a summer job that pays—or a job any time of year that he gets paid for-one of the best parental assists and lessons you can deliver is to get your child to open a Roth IRA account.

 

Here's how a short summer job could turn into a tax-free $50,000:

• Parents can help kids fund an IRA. To be eligible to open an IRA your child must have earned income. That's the summer job. But here’s the neat part for parents, grandparents, aunts, uncles (you get the idea): The child's IRA contribution doesn’t have to come out of his or her earnings. Anyone can provide the actual money that goes into the IRA. The only stipulation is that the child actually earned an equal (or greater) amount during that tax year. So let’s say your daughter makes $2,000 this summer. She is eligible to contribute $2,000 in the IRA, but you could be the one to give her $2,000 of your own money to fund the IRA.

• Introduce the Matching Contribution Concept. Let’s face it, suggesting a 15 year old, or 20 year set aside summer earnings for some goal 50 or 60 years off is not going to go over too well. But at the same time, maybe you don’t have to finance 100 percent of the IRA either. How about offering a generous matching contribution deal: For every $10 your child contributes you will contribute $50 or $100. Just remember the child must have earnings equal to the total amount contributed.

• Show the Carrot. You’ll want to provide incentive to do this. I’d pull up a simple future-value calculator and show what the investment today can grow to in the future. For example, a $2,000 investment that grows at an annualized 6 percent –that seems like a rational rate of return for a long-term goal—will be worth close to $50,000 in 55 years. And that's just for one year's contribution. Do this for a few years while your kid is in high school and college and you’ve given them an absolutely huge assist on their future security.

• Choose the Roth IRA. There’s absolutely no reason to choose the traditional IRA. It's not as if the upfront tax deduction on a traditional IRA contribution will be of any value to a child with limited income. The prospect of 100 percent tax-free withdrawals in retirement from a Roth IRA is the better deal. Besides, the money contributed to a Roth can always be withdrawn for any reason without any tax or penalty. It's just the earnings on those contributions that must stay invested until age 59 ½ to qualify for tax-free withdrawals. Of course, you don’t want your child to withdraw the money for a spring break jaunt to Cabo. But explain that they can in fact access their contributions and discuss what constitutes a true emergency.

• Don't Worry about the Impact on College Financial Aid. Money a parent or child has invested in a qualified retirement account is not part of the calculation used to determine a family's financial aid eligibility.

 

How to Discern Good from Bad Financial Advice

Carla Fried

If you’re looking for financial advice it’s not like you have to venture far and wide to find it. Friends, family, financial advisers and all manner of media are standing by ready to offer up an opinion. But here’s where the old quantity v. quality conundrum comes into play: how do you know if the advice is any good? Here are three signs you are being given good advice:

1. The downside is explained as well as the upside. Be circumspect about any advice, or adviser, that tries to sell you on something based solely on how much you could make. Before you invest a penny the most important question is: what’s my risk? Ideally you won’t even have to ask the question. The surest sign you’re dealing with someone who has your best interests at heart is if they volunteer this information. There’s nothing wrong with an investment that has risk. In fact, risk is a part of investing. Your goal is to understand the risks involved and decide if they are appropriate for you.

2. It’s personal. Good advice is tailored to your specific needs and takes into account your entire financial situation. If you are working with a financial advisor, they should be just as focused on your debts as how to invest your money, and should spend time to understand exactly what your long-term goals are before ever recommending a course of action. Same goes with advice doled out by friends and family. No matter how well intentioned it may be you should stop and ask yourself: But does it make sense for me? An uncle who is 40 years older than you may be giving advice that is appropriate for his life-stage, not yours. A friend who has a few more zeroes attached to her net worth may not be as attuned to the financial issues you are dealing with. Bad advice isn’t always nefarious; it can come from people who truly want the best for you, but that doesn’t mean they actually know what’s best.

3. There’s no incentive to sell you. Professional financial advice comes at a cost. You are receiving a service that you should gladly pay for. The issue is exactly how you pay for it. A broker or advisor who is compensated through the commissions she earns when you buy (or sell) something has an incentive to push you toward decisions that will generate that commission.

At the very least, that advisor should spell out exactly what they stand to make on an investment. For example, if you are investing in mutual funds, it is your job to make sure you understand what “share class” your advisor is putting you into. So-called “B” shares have no upfront sales load for you, but the ongoing annual fee charge—called the expense ratio-will be higher than other share classes because part of the charge goes back to your advisor to pay her for putting you into the fund. That fee is charged year in and year out; whether it’s an extra 0.25% or 0.50 percent, or even more it ends up costing you plenty. An alternative is to work with a fee-only financial advisor who charges a flat hourly fee, or annual fee—or a percentage of your assets—and thus has no incentive for you to actively trade to generate commissions. It’s also more likely that a fee-only advisor will be inclined to recommend low-cost mutual funds or exchange-traded-funds. You can learn more about fee-only advisors at the website of the National Association of Personal Financial Advisors.

Investing by the Decade

Josh Smith

When it comes to investing in your future, it’s not how much money that matters the most, it’s how old you are. Obviously the younger you start investing the better, but if you invest in an age-appropriate manner you can make smart investing choices easily and most importantly balance growth with security.

If you want to get specific, you can go to your bank’s (or other financial services provider’s) website and look into financial planning; but for basic allocation you can subtract your age from 110 to find out how much of your portfolio should be in stocks and how much should be in bonds. You may hear different numbers to subtract from as the number changes from 100 to 110 depending who you ask, but keep in mind this is just the start, not the end of your financial planning. If you want to be more aggressive add 10 years, if moderation is your style then subtract 10.

This means that if you are 30 you should invest 80% of your portfolio in stocks and the rest in bonds. The best part about this rule is that you’ll be able to adjust your investment in the right direction as you age without a ton of thought and research.

Investing in your 20’s: Don’t be reckless, but now is the time you can afford to take a risk on your investments. It’s a fun time to take some money outside of your 401k and invest in the stock market. It’s a great time to live cheap and start to garner some savings.

Investing in your 30’s: When your 30’s arrive, take stock of your life situation and how it has changed. If you are starting or planning a family, this could be a good time to start looking at a 529 plan. This also is a good time to make sure you’ve said farewell to high interest debt.

Investing in your 40’s: Enjoy this time. You are probably near the peak of your earning potential and have more income than expenses which means you can invest more. This is also a good time to take stock of how much you think you will need when you retire and a reminder to make sure you aren’t taking as many risks as you did in your 20’s. Now may be a good time to sell some stocks that have done well and invest elsewhere.

Investing in your 50’s: With the goal in sight, you may want to start sprinting, but make sure you pick up the pace in a smart manner so you don’t collapse before the finish line. Rather than taking riskier investments, look into catch-up contributions to your 401k which can help you get ready for retirement. These contributions may not seem like much, but you still have 10 to 15 years for them to grow. Most of all make sure you are investing appropriately. Too many people 50 and older lost big during the recent downturn thanks to poor asset allocation.

As always, your financial situation is different than the next person’s which means that you can benefit greatly from expert advice. If you have an employer provided 401k, ask your HR rep or the company handling the investments for free advice. Many times the company will offer free in-person consulting two to three times a year which can help you find the right mix for your age and life situation.

The ONE Best Move Financial Move

Carla Fried

It’s not every day in personal-finance-land that you come across a small adjustment to your investing strategy that can pay off big-time. That’s why I am such a fan of a ridiculously simple strategy I am going to call One Percentage Point More.

Okay, not exactly a barnburner of a name, but stick with me here for sec. What I am referring to is pushing yourself to increase your savings this year by one percentage point. So if you are socking away 10 percent in your company 401(k) plan, bump it up to 11 percent.

We both know that the difference in your take-home pay is going to border on the imperceptible; it won’t necessitate a huge life-style change. Yet the payoff is in fact huge.

Here’s an example I ginned up: You make $75,000 a year, you already have $100,000 saved up and you save 10 percent of your gross salary each year.

I’m going with a conservative assumption that your salary will increase at an average 3 percent rate each year. (Conservative, because, well, you rock and so too will your career.) One more assumption: You’ve got your money invested in a well-diversified portfolio of stocks and bonds that will deliver a 6 percent annualized return.

Drum roll time. If you keep socking away 10 percent of your salary each and every year, you will have more than $550,000 in 20 years. Not bad, eh?

But if right now you commit to a one-time, one-percentage point boost in your savings rate - that will give you nearly $600,000 in 20 years.

Now the grand finale. If you commit to increasing your savings rate by one percentage point each and every year you will have close to $750,000 in 20 years. That’s 36 percent more than what you would have if you just keep saving at your current rate. There’s a great calculator at the New York Times website that will show you the payoff from saving one percentage point more.

As I mentioned, siphoning off one percentage point more of your salary for long-term savings isn’t likely to send your monthly budget into disarray. It’s a really small tweak that has a huge payoff.

And in 2011 Uncle Sam is giving you a great assist. As you may have already noticed, if you typically pay into the Social Security program—it’s the FICA deduction on your pay stub-the amount you owe this year is lower. For 2011, the employee contribution rate has been reduced by 2 percentage points. A-ha. That’s two times as much as you need to set your One Percentage Point More strategy in motion. You can boost your savings this year and thanks to the Social Security payroll tax break, you still won’t see a dip in your take-home pay relative to 2010. For future years, how about making the commitment that at least one percentage point of every raise gets earmarked for your long-term savings? So if you get the 3 percent raise, vow to use 1 percentage point of it for savings. The other 2 percent is yours to spend (or save) as you desire.

What Your 401(k) Isn’t Telling You

Carla Fried



In the past few years there have been some smart innovations in how 401(k) plans are run. But while the changes are for the benefit of participants-that’s us-there are some hidden consequences that can impede your ability to build a secure retirement:


Here’s what your 401(k) might not be telling you:

• Don’t Settle for the Default Contribution Rate. One of the best innovations in 401(k)s over the past few years is to automatically enroll new employees in a company’s plan rather than wait for the employee to sign on. (You can always opt-out of any plan you are enrolled in.) But when most plans automatically enroll workers they also typically set the employee’s contribution rate at 3 percent of salary.

Here’s what your 401(k) isn’t telling you: You will never reach your retirement goals if you save just 3 percent of your salary. Even if your employer kicks in a matching contribution, that’s not going to cut it. For anyone in their 20s, financial advisors typically recommend setting aside at least 10 percent (combined employer and employee contributions.) If you’re just getting started in your 30s and 40s, the advice is to aim to save 15 percent of your salary.

Now some 401(k) plans have also added an “auto-escalation” feature that periodically—once a year, or when you receive a raise-increases your 401(k) contribution rate. But they are the exception, not the norm. So it’s up to you to contact HR or your 401(k) plan and ask for your contribution rate to be increased. Aim for at least a 1 percent increase each year until you reach your 10 percent-15 percent target. And hey, this year push for a 2 percent increase. You won’t even see or feel the difference. As part of the recent tax bill that passed Congress, employee contributions into the Social Security system—that’s the FICA line item on your paycheck-have been reduced by 2 percentage points in 2011. Why not earmark that 2 percent “payroll tax break” for your 401(k) this year?


• Your Retirement Date is not the Same as the Target Date on Your Retirement Fund. Target-date retirement funds have become a popular option the past few years, and that’s a good development. Being able to have insta-diversification across an age-appropriate mix of stocks/bonds/cash in one fund is a heck of a lot easier than trying to make sense of choosing among a dozen or more individual funds offered in your plan.


But just make sure you understand how the fund company views your “target” retirement date. In the wake of the 2008 market crash, some 50-something employees invested in target date retirement funds with a 2010 or 2015 end date and were unpleasantly surprised to find out their funds had suffered big losses due to a big slug of stocks. That’s because most target-date funds are not focused on the date you are retiring-say age 62 or so-but instead are allocating the money on the assumption you will live well into your 80s or beyond. So while you may be focused on retiring in five years, the fund is focused on the need for your savings to continue to grow and support you for 20 or 30 more years. In the techno-speak of the 401(k) world this is known as the “To or Through” debate: does your target retirement fund allocate the assets to get you To retirement, or Through retirement? I am a big believer that you want to be investing Through retirement. But the takeaway here is to not assume anything, and understand exactly how your target fund operates and make sure you are comfortable with its assumptions, or that its allocations dovetail with your overall retirement savings strategy including your IRAs and other savings accounts.

• You’d be Better Off Not Investing in Our Company Stock. Or at least, not loading up on too much company stock. This has nothing to do with corporate loyalty, or the fact that you think your company is all-that. This is about sound portfolio management. And the sacrosanct rule here is to limit your investment in any individual issue to no more than 10 percent of your assets. Invest more than 10 percent in any single stock and you are taking too much risk, plain and simple. Yet a recent survey of 401(k) plan participants by Financial Engines reported that 23 percent of participants with access to company stock inside their 401(k) had more than 10 percent riding on their employer’s stock. Even if your firm makes its matching contribution into your account in company stock, most plans also give you the option of moving out of the company stock and into the other diversified funds offered in the plan. That’s a smart move to make today to ensure a more secure retirement.