Many of us are covered by one or more types of defined contribution retirement plans, such as a 401(k), 403(b), 457, or any of a number of other plans. What many of these plans have in common is that they are referred to as Cash Or Deferred Arrangements (CODA), as designated by the IRS. These plans are also often referred to as Qualified Retirement Plans (QRPs). Each type of plan has certain characteristics that are a little different from other plans, but most of them have the common characteristic of deductibility from current income and deferred taxation on growth. (Note that this list of plans does not include IRAs. IRAs have certain characteristics that are completely different from QRPs, and vice-versa.)
1. Each dollar you defer is worth more than a dollar. It’s true. As you defer money into your retirement account, each dollar that you defer could be worth as much as $1.54. How, you might ask?
Since you are not taxed on each dollar that has been deferred into the retirement account, your “take home” pay only reduces by the amount that is left over after taxation. For example, if you’re in the 25% income tax bracket, generally your income will only reduce by 75¢ for every dollar that you defer into your retirement plan. Therefore, the 75¢ that you’ve effectively “spent” is worth 33% more ($1.00) in your retirement account.
If you happened to be in the 35% income tax bracket, this works out to a 54% increase in the value of each dollar deferred. This doesn’t even take into account the potential for matching dollars from your employer!
2. Matching – FREE MONEY. Well, it’s not exactly free, you must defer some funds in order to take advantage of it, but other than that, your employer is actually chomping at the bit to give you this money. The reasons can be far-reaching, but the point is that it’s literally yours for the taking (and totally yours if you’re vested in the plan). It should be noted that some companies do not match your funds at any level in a plan.
So, what should you do about this? If you aren’t currently participating in your company’s 401(k) or other deferred compensation plan and they match your funds, you are throwing money away by not participating. Depending upon the options in your plan, you could be turning your back on as much as a 100% return on your investment – guaranteed! Everyone should take advantage of AT LEAST the matched portion of your deferred compensation plan. After that, it may make good sense to put money aside in a Roth IRA (up to the maximum annual amount), before adding more to your deferral to max out your 401(k).
3. Don’t Overload On Company Stock. Even (especially?) if you’re in a company where the stock has experienced dramatic increases in recent history, you need to make sure that your overall exposure to any one company is limited. A rule of thumb that I use is: no more than 5% of your overall net worth should be invested in any one company. If you are inclined to have a larger stake in your company because you work there and enjoy the sense of ownership, I wouldn’t put any more than 10% in that stock. The figure is doubled for the company that you work in because, at least presumably, you are more in tune with the value and internal events of that company and could make adjustments if an event were coming up that could seriously impact your holdings.
Of course, the reason behind this is to limit your exposure to the ebb and flow of a single company’s stock price. For example, what if you held stock in one company that amounted to 30% of your overall net worth, and that stock took a major hit of a 25% price reduction? This one event would have the impact of yanking down your net worth balance by 7.5% – quite a serious impact, to say the least. The folks at Enron (and countless other dot-com craze companies) found out the hard way how much damage can be done by having too large of an exposure in a single company.
4. Diversify, diversify, diversify. Most of us understand the concept of diversification, but how do you actually accomplish it?
In order to properly diversify, you need to review the available investment choices in your plan, and then use those choices to spread your investments among capitalization categories (large-cap and small-cap), as well as between value-oriented and growth oriented, as well as domestic companies and international companies. You should also consider what amount of fixed-income investment (bonds) makes the most sense in your portfolio.
Keep in mind, diversification doesn’t simply mean you put an equal amount of money in each available choice of investment. Each person needs to consider this individually, in respect to their overall portfolio and risk tolerance, including assets held outside of the deferred compensation plan, such as other IRAs or taxable accounts. You need to make a decision as to what allocation makes the most sense for you and apply it across all of your accounts. If you’re fairly young and have a lot of years to grow your funds (as well as recover from any downturns), you can probably take on a greater amount of risk. If you’re nearing retirement, most likely your risk profile will be much less risky.
5. Don’t Take A Loan. No matter how tempting it is, taking a loan out from your qualified retirement plan in more cases than not, results in derailing your hard work in saving and building up your account. Not only are you strapped with having to pay back the funds to your account (with interest), but you have also given up whatever growth might occur within your account (since the funds are being used for another purpose).
Experience tells us that you would be much better off to temporarily suspend or reduce your contributions to your retirement plan in order to save up money instead of taking a loan from your retirement plan. It may take a little while longer, but you’ll probably appreciate it a bit more as a result of your saving.