By Jerry Linebaugh
So, either you are reading this article because you have been investing for a while in your 401K or you are new potential saver to the 401K concept. I believe I can give some timely information for both audiences. This can be a tune up for experienced savers and something to help others get started.
First–right off the bat–the first thing everyone needs to see is that you may indeed have more money in your 401K than the value of your home. Or maybe you will have this amount or even much more by retirement but even seemingly large amounts 1 to 2 times your current home value may only produce a small amount of paycheck replacement. Maybe, and I mean maybe, you might be able to take out of your market invested 401K an amount of 4% to 5% of the balance and not run out so look at it this way.
You might need the income to last 20 or 30 plus years. You might actually spend more time in retirement than you worked. In that case you need a plan on how not only to build the money but also how to take it out. 401Ks are great for accumulation but better options are available for income planning during retirement. Yes, you may be able to roll your money penalty and tax free even while you are still working if you are over 59 and ½ but we will talk more on that in a minute. Right now, let’s look at the next most important thing you need to know…
Average Rate VS Effective Rate of return.
You must determine this rate and not understanding this could mean great disappointment at retirement. It is easy to figure but normally you won’t find what you need to determine it on your statements. But you can ask for it. Misunderstanding abounds and with grave consequences. So many people I sit with are fairly intelligent people. Most are good at what they do. They have a college degree or a lot of practice making them a go-to person in their field. Many times they are in their 50’s or much older when I first meet them. When I ask them what is their effective rate of return on their money right now, 95% of them pull out their statements and point to a figure.
I say to them, “Well that’s either your recent rate of return, perhaps this year or this quarter.” I explain to them that it could be your average rate of return over some longer period of time even back to the beginning but certainly not your effective rate of return. So to calculate your effective or your true net rate of return you simple ask the fiduciary or designated contact person appointed by the plan how much money you have put into the plan. This is call your basis. The difference between what you have put in and where you are today reveals the real or effective rate of return and shockingly it can reveal a negative number if you were saving before 2000-2003 or before 2008. Whatever number is revealed will be less than your published or average rate on your statements. You also need to see the amount of money your employer has given you and set to the side as well. Looking back over the last 10 to 20 years, this means you might have been better in the cash account in the 401k and just taking the match money vs taking unknown and unmanaged risks which are stocks and funds within the 401K investment platform. Losses have to be accounted for and it shows up in your effective rate of return.
How to get 100% Rate of Return in your 401K.
This is a simple thing. It assumes you have a 100% matching funds from your employer up to a limit. This will work with a 50% match as well but the example will produce a 50% rate of return of course. So we also assume that you will put your money into the cash equivalent account in the 401K and not in the market. Let’s say the match is 3% and you make $100,000 per year and the match is 100%. You put in $3000 then right? (100K x 3% = $3000). And your employer puts in $3000 which is the max match in this example. So at the end of the year you have 100% return on your money since you started with $3000 and now you have $6000. In 10 years you put in $30,000 and you now have $60,000. You may have slightly less if your employer is passing fees to you in the plan but over the last 10 years looking at effective rate of return, some people I have sat with would have been better off by a large measure. Do you really think you can beat a 100% rate of return looking over the last 10 years? For those who are in the market and are up right now, if you stay invested in the market through the next correction (some say is long overdue) you will be back to negative rate of return territory for who knows how long.
How to Select Investments
In most plans there is no way to get active management. So participants try to select what they feel might be good bets and get back to doing their job at work. Sadly without active management many people stayed in during the Dot Com crash of the 90’s or the crisis in 2000 to 2003 or the mortgage and banking crisis in 2008 and lost tons of money. Ask your contact if there is a “tactical management option” where all of your investing is managed by a team using logic and math. If there is not a tactical management option then ask to speak to a fiduciary and find out about how each product works. It’s scary how many people have their life savings in things they don’t understand.
For example many smart people I sit with can’t tell me what a bond is. In a word a bond is a debt. It’s an I.O.U. When you own bond funds it is where there is a manger of the fund with a whole bunch bonds or debts within the account. So you can lose money if the governments or companies that are paying on the debt stop paying or become slow pays due to insolvency. You can also lose money on bond funds if the rates start to go up. The fund manager will likely want to sell the old bonds to get the newer and higher rates on the newer bonds. This can sometimes result in a loss of principle even though no bond has defaulted! This is not a caution to not buy bonds or bond funds but this simple understanding needs to be in place on how bonds, bond fund, stocks and stock funds all work. It helps people to really know when to maybe they want to get out of the particular product. Also note that the managers that might be present in mutual funds or bond fund are not the same thing as having a tactical management firm over all your assets for sure and some 401ks do have this feature. If yours doesn’t then demand it. It can be added.
The Biggest Risk in Retirement might be tax risk.
So there are two types of 401Ks. Traditional and Roth. The majority of 401k plans available today are traditional 401K plans but about 50% of them also offer a Roth alternative. Roth allows you to pay the taxes due today and potentially grow the money and take it out tax free after 59 and ½. If taxes continue to go up particularly income taxes, then some believe you might actually be in a higher tax bracket in retirement. It works like this. If during your retirement years you have enough money to pull a monthly check that would shove you into a similar tax bracket you are in now while you are working then it may be a draw with neither being better than the other.
If you do end up in a similar bracket at retirement because your lifestyle is similar while you were working and the taxes are higher when you start to access your money, then you would have been better off saving in a Roth 401K option or some other tax advantaged program for tax free income later. However if you downsize your lifestyle considerably and assuming the rates or thresholds don’t go up considerably then a traditional 401K still might be the best medicine. It’s time to have this conversation now and to continue to have discussion with a financial advisor all the way till retirement.
When Can I join and how much do I need to contribute?
Only about half of the 401K plans allow new hires to start putting money away into the 401K. Some companies require recent hires to wait two or three months and others require a wait of a year. But when you are eligible you need to start. We practice a rule of thumb that a person needs at least 6 months of liquid funds available to them for emergencies and at least a year’s worth if the client is retired. You need to create this account outside of the 401K because most any withdrawal of money no matter if it’s a Roth or Traditional 401K will incur a 10% early access penalty if you are younger than 59 and ½. If a traditional 401k any access at any time and at any age will be subject to reporting to the IRS for income tax calculations so save your 6 month to 1 year emergency fund outside of the 401K.
After this emergency account is set up, it’s time to start socking it away in the 401K as much as you can. You need to think about adjusting your lifestyle around putting the maximum away but at least 8% to insure a decent retirement replacement check. Maximum funding levels for 2015 are $18,000 per year and for people age 50 and older the IRS allows an extra amount of $6000 for a total of $24,000. If your company gives a match, then the combined annual funding can be up to 59,000 for age 50 or older folks.
Should I leave my money in the 401K when I retire?
Probably not. A 401k and the common investment choices within were designed for accumulation. You can roll this money in most 401K plans penalty and tax free around age 60 and custom design a plan for income and preservation. You can roll to an IRA and use a combination of cash, some managed money but light on the equites and low to no fee annuities called fixed indexed annuities where you only gamble the rate of return from year to year not the principle. To be sure there are a lot of poorly structured fixed indexed annuities but that is for another conversation. However there are a few really good ones as well. Do you know anyone who has a pension? Know anyone who got a structured settlement after a lawsuit? Most all pensions and most structured settlements are annuities and they have been around for hundreds of years. You need to look to get as much guaranteed income as you can for retirement assuming you are near or at retirement age.
Fixed Indexed annuities should be part of this solution because not only to they offer principle protection you can also get 4%, 5% and sometimes even a 6% lifetime income stream regardless the rate of return you may get after you turn on your income stream. You can set them up for joint income or have any remaining money not paid to you before death, paid to someone else. Having some of the money tactically mangaged outside of your annuities can give you increasing income. Learn about income portfolios which can include certain securities and certainly the right type of annuities. Income portfolios look a lot different from accumulation portfolios and for good reason—you can’t just keep working to overcome big losses once you are near or in retirement. Remember, Warren Buffets first two rules in investing, “Never lose money” and rule number two, “Never forget rule number one”. If make this your guiding principle then you wont let people steer you down the wrong path.
Jerry Linebaugh is the founder of JLine Financial in Denham Springs, LA.