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Ask Dr. Don

Ask Dr. Don

Today Dr. Don discusses 401(k)s for beginning investors and IRA early withdrawal penalties.

401(k)s for beginning investors


Dear Dr. Don,
My husband just started a new job. He's 23 years old, and this is his first opportunity to invest in a 401(k) plan. We're certain we want to participate in the plan, but uncertain about how to choose the investments. The information packets don't seem to help. Can you explain details that we should know about a 401(k)? My husband has the option to use a percentage of his 401(k) money to invest in stocks. Can you give us some tips about how to invest the plan in stocks and tell us what we should be aware of? Thanks!
Kim Kaplan

Dear Kim,
It's great that you're starting out investing in your retirement in your 20s. The earlier you put retirement money to work, the easier it is to meet your financial goal of a secure retirement. Don't forget to invest some money outside of the plan for the shorter-term financial goals, too, like the down payment for a house or car.

Make sure you understand the provision of the plan. Many companies fully or partially match their employees' contributions. At a minimum your husband should contribute enough to the plan to maximize the employer's matching contributions.

Letting 401(k) plan participants invest in individual stocks is a fairly recent phenomena and still not widespread among plan providers. I actually can't recommend that he invest in individual stocks when he's just starting out investing in a 401(k) plan, unless his employer is giving him a deal on the company's stock. It would be more appropriate to start out investing in a rather broadly diversified portfolio of stocks.

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A diversified portfolio reduces volatility (price swings) in the portfolio's value. There are three principal ways of building a diversified portfolio with small investments. One way is to invest in mutual funds. Mutual fund investors receive the return earned on the holdings in the fund's portfolio less any fees or expenses. A no-load mutual fund doesn't charge a sales commission but still charges management and marketing expenses. You can review a fund's expenses either in its prospectus or online using Morningstar.com. Mutual funds indexed to various stock and bond benchmarks can be reviewed on Indexfunds.com.

The second method is to buy shares in exchange traded stock indexes. For example QQQ is the trading (ticker) symbol for the NASDAQ 100 Trust Shares. Buy a share of QQQ and you are buying fractional ownership of the 100 stocks that comprise the NASDAQ 100. The S&P 500 has its own trust shares trading as SPY, but commonly called spyders. Thirdly, if the plan allows it, he could create his own portfolio of stocks using a site like FOLIOfn.com, or Netfolio.com. These portfolio sites have different approaches to portfolio construction. He can buy a portfolio off the rack, or create a customized portfolio.

Just starting out, it's important to manage your fees, commissions and expenses as part of choosing your investments. A $10 brokerage commission on a $100 biweekly investment means a 10 percent transaction cost to get in to the investment. A mutual fund that has an annual expense ratio of 1.5 percent will act as a drag on your returns. Put together a table that compares the expenses associated with the three approaches. For example, FOLIOfn charges either $29.95 a month or $295 a year to hold up to three portfolios. That's almost 3 percent on a $10,000 portfolio, actually more than that on a percentage basis because the $10,000 was invested over the first year so the average balance for the year would be less.

You'll also want to keep your asset allocation in mind. That is, you'll want different types of investments to decrease risk and volatility. Check out this Bankrate.com article on asset allocation.

Another great place to learn more about 401(k) investing is at SmartMoneyUniversity.

IRA penalty kick

Dear Dr. Don,
What are the consequences of early withdrawal from a traditional IRA? Is it a good idea to pay debt/credit cards with a withdrawal? I am 37, have $77,000 in a traditional IRA, would like to pay off $10,000 to $15,000 in credit card debt.
Jane Juncture

Dear Jane,
When you withdraw money from your IRA, you'll have to pay income taxes and a 10 percent penalty on the withdrawal. The money would have been taxed when you took a distribution in retirement, so the difference is the 10 percent penalty. All of a sudden it doesn't sound so bad, does it? If you're paying 17 percent on the credit cards, then taking the 10 percent penalty doesn't look too bad.

Well, let's think this through. Let's say you have a marginal federal income tax rate of 28 percent, and a state tax rate of 7 percent. So after considering income taxes and the 10 percent penalty, you'll need to withdraw about $27,273 from your IRA to have $15,000 to pay off the credit card debt. If you earned 8 percent on that money over the next 28 years, at age 65 the $27,273 would be worth $235,000 (before taxes).

One way to avoid the penalty is to annuitize your IRA. You would start taking annual distributions from your IRA. The problem is that you would have to continue those annual distributions for five years or until age 59½ -- whichever is longer. It's a long-term solution to what should be a short-term problem. I don't recommend this alternative but if you want to pursue it, Smartmoney.com has a worksheet that will help you determine the annual distribution on your IRA.

If you'd like to make a comment on this story,
e-mail bankrate editors.

--Posted: Oct. 23, 2000

Bankrate.com writers base their answers on our editorial content and advice of financial professionals. We make no claims or representations about the accuracy, timeliness or completeness of such content, advice or the answers provided to you. Our content, advice and answers are intended only to assist you with your financial decisions. However, by its nature such information is broad in scope. Your financial situation is unique, and our content, advice and answers may not be appropriate for your situation. Accordingly, we recommend that you get different opinions and seek the advice of your accountant and other financial advisers before making any final decisions or implementing any financial or investment strategy.

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