Mastering Your 401(k)

With the emergence of the 401(k) as the primary retirement plan for workers, millions of you have become responsible for complex financial decisions once handled by pension professionals. Not only do you have to choose when, where and how much to save for retirement, you have to figure out how to manage those savings so that you don’t:  1. run out of money before you die;  2. run afoul of tax rules resulting in unexpected taxes and penalties; or  3. leave any leftovers in a form that deprives your heirs of benefits. Even those of you who have professional help from a financial adviser may find that you want to understand the basics, if only to help you sleep at night and explore the haunting question, “Will I have enough?”

The Buildup

Beginning in your 20s and throughout your working years, you’ve had plenty of claims on your income—a home and a family chief among them. But you should also have saved early and often to have enough in retirement. But if you haven’t, you still have choices.

Begin contributing immediately. Anytime you start a new job, enroll in the 401(k) plan if it’s offered. If your company enrolls you automatically—don’t opt out. Every extra year your account has to compound means more money in your pocket when you retire.

Get the match. Set your contributions high enough to take full advantage of any match your company offers. The match is free money—don’t leave it on the table.

Choose investments that fit you. Over the long haul stocks have turned in the best performance, so if you’re in your 50s, look to put a good chunk of your money into the stock market. (But be cautious about investing in company stock. You’re already depending on your employer for your paycheck and benefits, so consider putting most of your retirement eggs in another basket.) As you grow older, you can shift some of your money into more stable investments, such as bonds, and, as you approach retirement, some into cash, such as certificates of deposit (CDs) or U.S. Treasury securities.

Rebalance. Once you’ve chosen your investments, decide how much of each type you want—say, 60 percent in stocks and 40 percent in bonds—and periodically check to see if your portfolio is within these limits. When the stock market has been doing well, you’ll likely find your stock percentage has gotten above the assigned level, which will be a reminder to sell some and shift the proceeds to bonds.

Likewise, in periods of falling interest rates, which push up bond prices, you may see your portfolio becoming too heavy on bonds, telling you it’s time to sell some and shift that money back to stocks.

Rebalancing nudges you not only to sell some of whatever asset has been riding high but also to buy those that have been not doing so well—in other words to sell high and buy low, which can boost your return. For example, when the market soared during the late 1990s, rebalancers sold some stock and bought bonds. When the market went south and the Federal Reserve cut interest rates, bonds got a big boost. Rebalancers who had sold stocks during their rise and shifted those gains to bonds benefited from that rise.

Roll it over. When you leave one job, there’s a temptation to pull your money out of the former employer’s plan and spend it. That triggers taxes, often penalties, and curbs your nest egg’s tax-deferred growth. Instead, shift the old balance to the new employer’s plan, if there is one, or roll it over into an IRA. And make sure the money doesn’t come into your possession, which can trigger taxes and possibly penalties. Instead, do a direct, or “trustee-to-trustee,” transfer—ask your benefits department for help—so the money goes straight into the new account.

Take the saver’s credit if you’re eligible.  The federal government wants you to save, and if you are a low-income worker, it is willing to chip in to help you. If you earn less than certain levels—this year, it’s $53,000 for a married couple, $26,500 for a single—you can get a federal tax credit and save as much as $2,000, depending on your income and how much you put into retirement programs. For details, check IRS Publication 590, Chapter 5, at www.irs.gov.

Don’t stop investing during a bad market. A 401(k) is, in effect, a “dollar-cost averaging” program; that is, as you make your regular contributions you buy more shares when the market is down, fewer when it is up. Those extra shares bought in a time like this will yield bigger gains when the market comes back.

Don’t borrow from your 401(k). Studies show that about one in five 401(k) participants has a loan outstanding and the average balance was just over $7,000. People in this situation are paying interest to themselves, true, but they’re also losing tax-deferred earnings on the money they’ve taken out. And if they leave their jobs, they must repay the loan or end up owing taxes and penalties.

Stay away from 401(k) debit cards. These cards make it ultra-easy to tap your account. The best way to maximize your 401(k) is to put money in—and leave it there.

The Spend Down

Your working career is over or winding down and you’re drawing on your assets. These years involve uncertainty—for example, do you know when you’ll die?—and they also offer less time to correct a mistake. So it’s important to think ahead and be careful.

Decide where to keep your account. If you have more than a minimal balance, you are allowed to leave it in your account with your former employer. But in most cases you’ll want to roll the money over into an IRA, which typically gives you more investment choices and is much more flexible when it comes to bequeathing what’s left to your heirs. Beneficiaries who inherit a traditional IRA can take minimum required distributions each year based on their life expectancy and leave the rest to grow tax-deferred.

Be aware of penalties. If you’re retiring early and think you may need income, leaving your balance in the 401(k) has an advantage: Withdrawals can be penalty-free beginning at age 55. For an IRA, the penalty-free age is 591⁄2. With an IRA you must begin taking “required minimum distributions” by age 701⁄2; if you’re still working, that rule doesn’t apply to a 401(k) you have with your employer. Withdrawals from both traditional 401(k)s and IRAs are taxable as ordinary income—and if you withdraw too soon or too late you can be hit with penalties.

The actual deadline for taking your required distribution from your IRA is April 1 of the year after the year in which you turn 70 and a half. But generally it’s a good idea to take the first withdrawal in the year you turn 70 and a half. If you wait until the next year, you’ll also have to take the withdrawal for that year, giving you two in one year and potentially boosting your tax bracket. For years after the one in which you turn 70 and a half, the deadline is Dec. 31. Note: the Roth versions of 401(k)s and IRAs are tax-free and have no mandatory withdrawals.

If you need money early, there’s a way to avoid penalties. With a traditional 401(k) or IRA, you are allowed to take money out before age 591⁄2 if you use what the IRS calls “a series of substantially equal payments.” You must use one of three IRS-approved methods for calculating the payments, and there are penalties if you don’t stick to the schedule. Also, with a 401(k), you must have left your job before starting the payments. This arrangement is very complicated and you should get expert advice before using it, but it does exist and can be very helpful in certain situations.

Don’t become too conservative. Life expectancy for a 65-year-old today is past 80, and half of those 65-year-olds will live even longer. This means that retirees in good health are likely to need growth in their retirement assets to make their money last as long as they do. Bonds, certificates of deposit and the like are good at preventing losses, but historically they haven’t provided as much growth as stocks. Thus, you’re likely to be better off if you keep some of your assets in stocks, especially in your earliest retirement years.

In a down market, consider taking distributions in stock. One of the perils of 401(k), IRA and similar accounts is that you may have to sell assets when they’ve lost value. This is why shifting some money to bonds and cash is recommended. However, if you must take a required distribution but don’t need the money right away, consider shifting mutual fund shares or stocks to a taxable account. You have to pay tax on the value of the shares, but later on, whatever value they gain in the taxable account will be taxed at lower capital gains rates.

Protect your heirs. Keep your beneficiary designations up to date. Marriages, births, divorces, deaths and other changes must be noted or your money could end up going where you never intended—to an ex-spouse, for example. Updating this information isn’t difficult—you just have to remember to do it.

Al Crenshaw wrote for the Washington Post business section for 24 years.