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FAQ about 401(k)s -- Page 2

I've changed jobs and am confused about what to do with my 401(k) account from my old job. I was told that I could either cash out or roll it over into an IRA account. I already have a traditional IRA. What should I do?

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Avoid the temptation to just take the money and pay the taxes and penalties.

Most employers require you to close the account if you have less than $5,000 in the account. Keep your options open by doing a direct transfer into an IRA rollover account. If you keep the money separate from your traditional IRA account you'll be able to move the IRA rollover account into your new employers' 401(k) plan after you've met their length of employment requirement.

A direct transfer means the money is transferred from the 401(k) account directly into the IRA Rollover account.

If you accept a check, then the money in the account will be subject to mandatory withholding. That means that 20 percent of the money in the account will be sent to the government. Fully funding the IRA rollover will then require you to come up with an amount equal to the withheld amount to deposit with the check. Otherwise the withheld amount will be treated as an early distribution and is subject to income taxes and a 10 percent penalty. It's much easier to just do a direct transfer.

Where to transfer the money? There are literally thousands of choices. Remember that you aren't obligated to later roll the money into your new employer's 401(k) account. It can stay in the IRA Rollover account. My rule of thumb for small investors is to concentrate your investments in diversified mutual funds. If you have $5,000 to invest you don't need five mutual funds. One or two will be just fine.

I suggest that you deal directly with a no-load mutual fund family such as Dodge & Cox, Federated, Fidelity, Janus, or Vanguard. You're trying to manage the annual expenses in the mutual funds, avoid sales loads and not invest in annuities.

Morningstar is a good site to shop for mutual funds. Some small investors like the idea of a hybrid fund that invests in both stocks and bonds. Two examples of this type of fund are Vanguard's Wellington Fund and Dodge & Cox's Balanced of page

I'm twenty-something and have the opportunity to participate in my company's 401(k) plan with a 50 percent match. How should I allocate my money at this point in my life?

This is the most important question an investor can ask. Deciding on an asset allocation and rebalancing your portfolio every year to keep the percentages where you want them are the keys to maximizing returns and minimizing risk.

Before you can decide on an asset allocation for your 401(k) plan, you need to understand the three main mutual fund categories:

1. Investment objective: Conservative or aggressive? Life's a trade-off.
Conservative investors trade lower returns for lower risk and preservation of capital. Owning bonds is less risky than owning stocks, and owning stocks in large U.S. companies is less risky than owning stocks in small, foreign companies. The older you get, the more conservative your investing should become.

Aggressive investors trade higher risks and periods of high anxiety for higher returns. With a lifetime of investing ahead of you, you can afford to take a more aggressive approach; but you have to stay the course. The stock market is volatile; when it takes a dive, you have to hold tight, believing it will follow its historical pattern of bouncing back and moving forward in the future.

2. Investment style: Growth, value or blend?
Growth funds look for companies whose sales and earnings are growing faster than average; the stock price is usually expensive in relation to current earnings. In other words, the price/earnings ratio (P/E ratio) will be high.

Value style funds look for companies with stock prices that are cheap, relative to their current earnings. In other words, the P/E ratio will be low. Read "What is value investing?" for more on this investment style.

Blend funds use a combination of investment styles.

3. Size of company: Large-cap, mid-cap or small-cap?
"Cap" means "capitalization." A company's market-capitalization is its share price multiplied by the number of shares owned by investors.

Large-cap funds invest in large companies; mid-cap funds in medium-size companies; small-cap funds in small companies. For more on this, read "What is market capitalization?"

Suggested asset allocations


Medium risk






















For more information on the various types of mutual funds, visit the Morningstar Web site. Morningstar is the leading provider of independent data, analysis and editorial commentary on mutual funds.

Do yourself a favor and use the free Morningstar "Quicktake Reports" to check out the mutual funds offered by your company's 401(k) plan. Among other things you'll learn the name and tenure of the fund managers, what fees they charge, investment styles, size of companies the funds invest in, performance data and risk/return ratings.

If this is too much information to digest before it's time to make your first 401(k) contribution, don't despair: Put the entire contribution in an S&P 500 index fund, or other large-cap, blend fund, until you've had time to decide what allocation you're going to feel comfortable with and what individual funds you wish to of page

I want to diversify my 401(k) investments but I am confused by the descriptions for the types of mutual fund choices I have. Could you explain: index funds, emerging growth, value, overseas, aggressive growth and bond funds?

You need to understand what an "index" is before you can understand what an "index fund" is.

  • Index: An "index" measures and reports the performance of a particular group of stocks. It's a benchmark, or bogey, for the group it represents. The benchmark for most mutual funds is the S&P 500.
  • S&P 500 index: This index measures the total change in market value of America's 500 most widely held public companies. The goal of most stock mutual funds is to beat the S&P 500. Over the long haul, hardly any of them do, so an S&P 500 index fund is a good place to put your large-cap investment dollars.
  • Index fund: An "index fund" buys the same stocks that make up a particular "index." Vanguard is the 800-pound gorilla of index fund investing. An index fund that mirrors the S&P 500 is a large-cap fund, holding a blend of growth and value stocks. Expect your investment in this type of fund to be boring, effortless and profitable. There are indexes to measure every segment of the investment market. To learn more, read "You'll need an index to do the job."

Emerging growth fund
An emerging growth fund buys stocks in companies in less-developed countries, such as Mexico, Malaysia, Chile, Jordan, the Philippines and Argentina. Because of the political and economic instability of the emerging markets, these funds are volatile and risky.

Overseas funds
Overseas funds buy stocks and bonds in foreign companies. Global funds have a mix of U.S. and foreign holdings.

Aggressive growth
Aggressive growth funds invest in companies whose sales and earnings are expected to soar in the future. These funds have periods of huge losses and periods of huge gains; you're betting that over time the gains will far outweigh the losses. You need a strong stomach and long time frame to invest in this type of fund.

Bond funds
Bond funds invest in bonds. A conservative fund invests in U.S. government bonds; an aggressive fund invests in high-yield or "junk bonds."

-- Updated: June 22, 2004




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