Already Contributing to Your 401(k) ... Here's How to Optimize It
From contributing the max to cashing in on institutional pricing, here are six tips to make the most of what’s likely your biggest source of retirement savings.
With traditional pensions fading away in the private sector, the importance of 401(k) plans for U.S. workers has grown exponentially. For most workers, other than Social Security, whatever has accumulated over an individual’s career in 401(k) plans (which they end up rolling over into IRAs at some point) will likely represent the bulk of their retirement savings.
While saving and investing in a 401(k) plan are obviously important initial steps, individuals should also take a closer look at their plan to identify ways to optimize its use. Here are six tips you may want to consider.
1. Ramp up your contributions later in your career.
Late in their careers, many 401(k) savers find themselves behind in their savings goals. The good news is that 401(k) plans offer the ability to dramatically increase late career savings. Before going all-out on your 401(k) contributions though, ensure you have enough liquid assets to handle a financial emergency if one arises.
There are three types of 401(k) contributions available, but not all company plans make each type available to employees.
- Almost all plans offer pretax contributions, whereby you get the tax deduction up front on your contribution, and your withdrawals are taxed as ordinary income in retirement.
- Some company plans also make Roth 401(k) contributions available. With Roth contributions, you do not receive the tax deduction up front, but your withdrawals in retirement will be tax-free.
- A third type offered by a smaller number of companies includes an after-tax component, where you can make additional contributions beyond pretax or Roth contributions. With after-tax contributions, no tax deduction is received up front or in retirement, but there are other advantages, which we’ll get into in a bit.
With catch-up contributions, savers 50 and older can contribute up to $24,500 total in any combination of pretax or Roth contributions in 2018. If you are already maxing out these contributions, and still have funds to invest, consider investing in the after-tax 401(k) portion of your plan if it is offered. With after-tax contributions, you can increase your 401(k) contributions beyond the $24,500 limit.
If you are 50 or older, the combined contributions from you and your employer for pretax, Roth and after-tax 401(k) accounts add up to $61,000 in 2018. Some plans may even allow you to convert your after-tax account into a Roth 401(k) account, thereby allowing you to avoid taxation of your withdrawals in retirement, although tax would be due on any investment gains at the time of the conversion. This is a great way to allocate additional dollars into a Roth account beyond the annual limits. The Tax Cuts and Jobs Act temporarily reduced tax rates until 2026, so it may be a good idea to pay taxes now on at least some of your investments.
2. Try to maximize investment performance.
Everyone wishes to maximize their investment performance, but consider that 401(k) investment performance may matter more than you think. According to a 2018 analysis by Prudential, an additional half of a percent (50 basis points) of investment returns starting at age 23 and lasting over a lifetime, could help those assets last an additional seven years in retirement. When you consider that the average life expectancy for a 65-year-old today is 18 years, those seven years gained will represent over one-third of retirement.
Underperformance in your 401(k) plan will cost you as you may have to increase your out-of-pocket contributions, delay retirement or suffer a lower standard of living in retirement. Here are two considerations that may help you improve your investment performance:
- Successful investing is not always about utilizing the cheapest funds. Fees, of course, matter, however investors must analyze cost in a broader context of overall value. Are your investments providing adequate diversification and exposure to market risk that will help you maximize investment performance over the long term?
- Most investors would likely benefit from a thoughtful mix of active and passive investments. Index funds can capture the same gains being experienced by the overall market, while high-performing active funds can provide higher returns (beta) than the market is generating. Larger employers have the buying power to bring in “best of breed” investment managers while negotiating low fees for their 401(k) participants.
3. Manage your investment risk.
Considering we are entering the 10th year of an equity bull market, 401(k) investors should be focusing on portfolio risk, especially for those nearing retirement. It’s at this point where it is critical to protect against sequence of returns risk, since a large market drop can devastate your retirement plans. Keep in mind that risks faced by individuals within defined contribution plans change, over time and a flexible investment approach that incorporates broad exposure across a variety of asset classes can help to better manage these risks. And, you do not have to do it all on your own. Target-date funds may be offered in your plan that can provide professional investment management, but make sure you look “under the hood” to see how the funds are constructed. Again, look for proper diversification and exposure to market risk.
4. Take advantage of institutional pricing.
You would think that investing in your workplace retirement plan, if offered, would be a no-brainer. However, some workers might decide to invest outside of the 401(k) plan offered by their employer for investable amounts that exceed a company match.
This is something that should generally be avoided. Why? Because of their buying power, 401(k)s typically provide access to funds that are institutionally priced, much lower than similar retail offerings found in brokerage accounts or IRAs. According to the Investment Company Institute, 401(k) plan participants who invested in equity mutual funds paid an average expense ratio that was 64% lower than the average expense ratio for a retail equity mutual fund.
Some small employers may have much higher 401(k) expense ratios, so do your homework to compare your options.
5. Consider taking advantage of a retirement income option, if your plan offers it.
Retirement income options, like guaranteed minimum withdrawal benefits (GMWBs) and immediate annuities provide workers with a guaranteed lifetime income stream in retirement, thereby mitigating longevity risk. While it’s nice to create a good pile of 401(k) wealth, you need to keep in mind that the main priority for 401(k) wealth is to generate retirement income for as long as it is needed.
Although fewer than half of retirement plans offer a guaranteed lifetime income product, a 2018 survey by Prudential and Morning Consult found that a majority of American workers, 56%, would turn part of their retirement plan balances into guaranteed lifetime income payments, if offered the option. Like mutual funds, annuities offered through a 401(k) plan will be institutionally priced and therefore have much lower fees than an annuity purchased in the retail market. With annuities, the insurer (and not your employer) takes on the contractual obligation to pay you income for life.
6. Access asset classes that are challenging to find in the retail world.
Your 401(k) may offer exposure to diversifying investment classes that you might not easily find elsewhere. For example, many 401(k) investors now have access to investments in private real estate. Most have access to stable value funds, which are conservative investment vehicles that guarantee not only a return of principal but a stated investment return as well for a given period of time (e.g., quarterly). These asset classes can provide additional benefits to your investment portfolio, whether it’s additional diversification, potential growth or guarantees.
The bottom line is that to have a secure retirement, it is going to be up to you. Employers are no longer guaranteeing workers' retirement income, so look closely at all your 401(k) has to offer and take advantage where you can.
Investing involves risk and it is possible to lose money when investing. Diversification does not ensure a profit or protect against a loss in declining markets. 1007554-00001-00
About the Author
Head of Financial Wellness Strategy, Prudential Financial
Vishal Jain is the Head of Financial Wellness Strategy and Development for Prudential Financial. He is responsible for defining Prudential's financial wellness strategy and partnering with a wide range of stakeholders across Prudential in developing and delivering financial wellness capabilities and solutions to the market. For more information, please contact Vishal at firstname.lastname@example.org.