There’s so much to love about a 401(k).

First, there’s all that free money. Ninety-five percent of employers currently make 401(k) contributions on behalf of their workers, chipping in an average of 3 percent of workers’ salaries, according to Profit Sharing/401(k) Council of America, or PSCA.

Then there’s the fact that 401(k) contributions are made with pretax earnings. That means you’re putting away hard-earned dollars before paying the Internal Revenue Service. Earnings in a 401(k) grow tax-deferred until you withdraw decades later, so your money compounds even more.

With so much going for them, it’s no surprise that most workers have come to embrace 401(k) plans. Nearly 78 percent of individuals who are eligible to participate in one have done so, and 401(k) assets now total $500 billion, according to the PSCA.

But enrolling in a 401(k) is not enough to ensure a profitable retirement, you need to properly fund and manage it.

With that in mind, here are some pointers to help you maximize the power of your plan.

Workers who steadily save in a plan throughout their careers until age 65 generally will be able to replace 83 percent to 103 percent of their preretirement income, according to The Employee Benefits Research Institute and the Investment Company Institute.
10 rules for savvy 401(k) investing
  1. Get in early.
  2. Fund up to the limit.
  3. Be careful of going on savings autopilot.
  4. Don’t let a new job torpedo your old 401(k).
  5. Diversify. Diversify. Diversify.
  6. Think before you borrow.
  7. Consider a Roth 401(k).
  8. Take advantage of catch-up contributions.
  9. Scrutinize the 401(k) before you’re hired.
  10. Cash out wisely as a retiree.

1. Get in early.

Enroll in a 401(k) as soon as you can and then be consistent about saving. There will always times when you think you can’t afford to put money away for the future. Whatever the reason — you’ve got to pay for a new baby, a mortgage, college tuition or even bills — there’s no stopping the clock. Resist the temptation to “opt out” of a 401(k) or cut back savings levels, even for a short while.

When you’re young that starting salary may feel thin enough as it is, so diverting money into a 401(k) plan may not be at the top of your list. It might help to remember that because money is put in pretax, a dollar stashed in your 401(k) is worth more than what will wind up in your paycheck anyway. For example, a $2,000 contribution to your 401(k) means you invest every penny of that $2,000. For an employee in the 25 percent tax bracket, that $2,000 left in your paycheck would quickly be cut down to $1,500 by taxes alone.

But the biggest windfall is the employer match, not tax breaks, says David Foster, a fee-only Certified Financial Planner in Cincinnati.

“To heck with the taxes. If your employer matches 50 cents on the dollar for your first $2,000, and you get $1,000, that’s a 50 percent return in year one. Nothing matches that.”

What to do if you’ve procrastinated? Don’t give up. Enroll pronto and help make up for lost time by contributing more than the minimum amount required to trigger your employer’s match.

2. Fund up to the limit.

The amount of money you can put into a 401(k) is set by law, although it has been increasing. Currently, individuals can save up to $15,500 in pretax dollars, and anyone 50 or older can stash up to $20,500 in 2007.

Today, many earners fall far short of those limits. In fact, just over a third of individuals who do save in a 401(k) put in just enough to trigger a full employer match, according to Hewitt Associates.

If the maximum seems too rich for your budget, then work toward it methodically.

“Acclimate yourself to saving,” says Dee Lee, a Certified Financial Planner and author of “Women & Money.” “It’s like working out. If you go in and try to do it all in one day, you’ll be so tired you’ll never do it again. But if you do a bit everyday, you’ll be able to do more. Saving in increments won’t hurt, especially if you’re new to it. And, over time, success breeds success. You’ll find that saving money can be addictive.”

3. Be careful of going on savings autopilot.

It’s become so important for people to save for retirement that many employers have begun to introduce automatic features to 401(k) plans. Prodded by a 2006 change in the federal law, more employers are automatically enrolling workers in 401(k)s, who must then make an effort to opt out of the program. Others trigger annual contribution increases of 1 percent or link them to pay raises. And still other plans choose investments so your money is invested on your behalf.

This is all very well and good, but your company shouldn’t have to play the parent. After all, while mom and dad have had your best interests at heart, they may not have always made the right decision for you. So, too, with automatic 401(k) plans. Yes, they’re getting workers to save. But there’s a downside for those who let their employers do their retirement planning for them.

“If a person is automatically enrolled, they tend to just go with the program. They don’t contribute enough. You want to make sure you qualify for the full match,” says David Wray, executive director of the PSCA.  

Plans that automatically enroll wage-earners generally divert 3 percent of their salary into the 401(k), says Wray. There’s only one problem. On average, employers require individuals to save 6 percent of their salary before matching contributions kick in. So you may be automatically enrolled, but you could still be missing out on those company contributions.

What’s more, workers who make the effort to sign up for a 401(k) tend to be more aggressive with how they invest their earnings. Just over four out of 10 employers with automatic enrollment invested the employee’s savings in stable value or money market funds — investments that don’t have the growth potential of other equity funds, according to Hewitt Associates.

While it may be reassuring to know your plan isn’t taking risks with your money, it’s a big mistake to assume safety comes without pitfalls. So make the effort to boost contributions and select investments based on your personal retirement goals.

4. Don’t let a new job torpedo your old 401(k).

It’s ironic. Workers often leave jobs to move to more profitable pastures. But when they do, their retirement savings take a big hit. According to Hewitt Associates, a whopping 45 percent of workers leaving their jobs cash out of their 401(k) plans.

That’s a very expensive mistake. Here’s why: Taking distributions from a 401(k) plan is not like tapping into a savings account. That’s because you’ll owe a 10 percent early withdrawal penalty if you’re younger than 59½, plus income taxes on the entire amount. Instead of squandering those savings, have the assets directly rolled into an IRA, where earnings can keep growing tax-deferred.

Oops. You didn’t roll over into an IRA? It’s not a lost cause.

You can still move 401(k) assets into an IRA but you have to move fast– within 60 days — and it will cost you. That’s because your former employer will automatically withhold 20 percent of assets when your 401(k) is cashed out. You must replace those when you fund your new IRA. But if you do manage to open a rollover account by the deadline, the 20 percent withholding that you replaced out-of-pocket will be reflected in your tax return, and you’ll wind out coming out even.

“It will be reflected like a wage withholding. Therefore, because that 20 percent was withheld, it will reduce the amount you owe or entitle you to a greater refund,” says Mark Luscombe, principal tax analyst at tax law publisher CCH.

5. Diversify. Diversify. Diversify.

Financial experts agree that the best way to hedge against risk is to diversify so that you own a variety of stocks and bonds. That means paying attention to funds — and company stock — that may be in your plan.

“Asset allocation is the most important thing,” says Dick Bellmer, chairman of the National Association of Personal Financial Advisors.

That’s a message more employees need to take to heart. These days, plans boast on average 19 funds, according to PSCA. But that doesn’t mean workers are necessarily spreading their risk. According to Hewitt Associates, workers generally invest 401(k)s in four asset classes.

One easy way to ensure that your investments are diversified is by investing in lifestyle funds, which automatically adjust holdings depending on age and retirement goals. Planners recommend them as a great way to get started, especially for younger workers who need help picking investments. However, as you approach retirement, you’ll need to tailor your investments to your personal goals.

And tread lightly if your company contributes matching funds exclusively in their stock, or if your shares have gone up. Those investments could quickly make up a good chunk of your 401(k) balance. And if that’s the case you’re at greater risk of watching your savings evaporate, should that single stock drop in value. So what’s the ideal limit?

“Personally, I like to see no more than 5 percent,” says Bellmer.

Many workers need to take this limit to heart. On average, company stock makes up 24 percent of 401(k) balances, according to PSCA.

If you want to rebalance your shares, there’s good news. It’s becoming easier to diversify. Employers may make you wait a certain period of time to do so, but 46 percent of plans that make matching contributions exclusively in company stock let employees diversify those shares at any time. That’s up from the 15 percent who did so back in 2001, according to Hewitt.

6. Think before you borrow.

Ideally, you’ll leave your 401(k) untouched until well into your retirement. Then again, life throws plenty of curve balls, and there may be a time when you want to borrow against your 401(k). In fact, most plans let you borrow up to 50 percent of your plan, up to $50,000.

Try to resist the temptation. “I think one of the most harmful things you can do is take a loan against your 401(k),” says Mike Scarborough, author of “401(k) Knowledge.” “People latch onto the idea that they’ll pay themselves interest, but it’s not that simple.”

If you must borrow, beware of the pitfalls and make an informed decision.

First, scratch that notion that you’re paying yourself back. When you take a loan from your 401(k), you will be paying back the borrowed funds with interest, but often it’s at a lower rate than the investment would otherwise gain. If you have to borrow from your retirement fund, too, it’s unlikely that you’ll be making enough in regular contributions. That’s replacing money that has been taken out, not growing the account.

Another pitfall: Some employers won’t let you make contributions until you pay back a loan.

Next, you don’t have an eternity to make good on the loan — just five years in most cases. If you lose your job or quit, you’ll put yourself at further risk. That’s because employers can allow you to keep repaying the loan, but they frequently don’t, experts say. The means your outstanding balance will be subject to income taxes plus the early withdrawal penalty.

Then there are fees. Seven out of 10 plans charge a one-time loan fee that can range from a modest $3 up to $100, according to the PSCA. And a quarter of programs charge an annual service fee on top of that.

With so many hazards, it’s not surprising that financial advisers often recommend borrowing money somewhere else. A home equity loan is one popular alternative, since interest is generally deductible and won’t be subject to time limits or put you at risk of defaulting if you lose or change jobs.

Or don’t borrow at all.

7. Consider a Roth 401(k).

You may not be aware of it, but employers have been busy rolling out a new addition to retirement programs: the Roth 401(k) plan. About 22 percent of employers now offer such plans, and that number is growing, according to Hewitt Associates.

As their name suggests, these new products blend elements of both a traditional 401(k)s and the Roth IRA.

Here’s the lowdown. Roth 401(k) contributions are made with after-tax dollars, so you’ll pay taxes now but not when earnings are withdrawn in later years. You can save as much as you do in a 401(k). For 2007, that’s $15,500, with an extra $5,000 for individuals over 50. Your take-home pay will be lower than with a regular 401(k), but there are advantages long-term.

For instance, the tax treatment makes Roth 401(k) plans potentially more lucrative for entry-level employees in low tax brackets, says Bill Baldwin at Pillar Financial Advisors.

“If you’re in the 15 percent or other low bracket you might consider the Roth 401(k) since you’ll likely owe higher taxes in the future,” he says.

If you have no idea what tax bracket you’ll be in when you retire and you want to hedge your bets taxwise, you can participate in both plans as long as the combined contributions don’t top the total $15,500 limit ($20,500 over 50).

8. Take advantage of catch-up contributions

Worried about hitting your retirement goals? Well, if you’re 50 or older, you get even more opportunities to save, thanks to so-called “catch-up” contributions. These allow you to chip in $5,000 more than the maximum. That’s not including employer contributions, either. In fact, 28 percent of companies match funds on employee’s catch-up contributions.

What’s that extra bit worth? Try this: A 50-year-old saver who stashes an additional $5,000 a year and earns 8 percent annually will have saved an extra $78,000 by the time he or she is 60.

9. Scrutinize the 401(k) before you’re hired

How many times have you looked for a new job and forgotten to ask about benefits?

That’s understandable. After all, most of us are more worried about putting our best foot forward. Salary demands loom large, and we might ask if there’s a 401(k). Beyond that? The specifics often get lost in the shuffle, says Scarborough.

“What’s the current match? Has the company raised or lowered it in the last few years? What are the investment offerings? Who runs the plan? No one thinks to ask those questions, but they’re prudent to ask,” says Scarborough. “I’ve heard of people getting the job and then they think to ask.”

To be sure, the last thing you want is a nasty shock of, say, finding out you have to wait a long time before you can start contributing. Ditto for unusually long vesting periods. (On average, 401(k) plans let you vest gradually, over a five-year period, according to the PSCA.) So speak up and find out more. If you’re in the enviable position of having more than a single offer, the difference between 401(k) plan benefits may make the difference between a good job and a great one.

10. Cash out wisely as a retiree.

A lifetime of diligent saving and careful planning has reaped big rewards and your 401(k) balance is proof of your hard work. Congratulations.

But your job’s not over. Tapping into your money requires navigating rules Kafka would love. Rush to grab cash and you could be making an expensive blunder. Ed Slott, CPA and author of “Your Complete Retirement Planning Road Map” says that between state and federal taxes, estate taxes and mistakes withdrawing money, up to a whopping 70 percent of assets could wind up going to the government. His message: Pay as much attention when withdrawing funds as you did accumulating them.

Generally, you can start taking distributions from your 401(k) without paying a penalty once you’re 59½. And you technically don’t have to touch the plan until you’re 70½.

So, how to get at those funds when the time finally hits? The answer boils down to three basic choices: Roll it over, lump sum or leave it alone.

If you want options, rolling it over into an IRA may prove to be your best choice. After all, you put yourself in control of the assets and can invest that IRA any way you want. Plus, you’ll defer taxes until you absolutely have to take the money out, or until that first required distribution hits at age 70½. If you’re over 55 but not yet 59, be careful. If you quit, get fired, or leave your job at age 55 or older, you can get 401(k), 403(b) or 457 funds out without paying the 10 percent early withdrawal penalty. That’s not true with an IRA. If you fall into that age gap but you think you need the money soon, it might not pay to do a rollover, says Slott.

You also want to be prepared to make decisions about how to invest your savings if you plan to move it to an IRA.

“The drawback is you move to an IRA and leave it in a money market fund or choose some crazy investment,” says Harold Evensky, a Certified Financial Planner in Coral Gables, Fla., and author of “Retirement Income Redesigned.”

Taking a lump-sum distribution means cashing out completely. Financial pros advise against this for two reasons. First, raiding your 401(k) will mean losing additional opportunities for assets to grow tax-deferred. Second, it’s expensive. After all, you’ll owe federal and state income taxes on the balance once you cash out. And while there’s no getting around taxes on 401(k) withdrawals, “paying taxes sooner than you have to is a bad mistake,” says Evensky.

If you like your 401(k) and find its investment choices sufficient, leave it alone. You won’t have access to other investments outside the plan, but keeping your assets where they are is the easiest choice.

Finally, bear in mind that you’ll probably do best seeking the advice of a financial adviser with experience in retirement planning before you withdraw funds. There may be money that’s easier and cheaper to get out of a brokerage account or IRA before touching the 401(k). You’ve got to look at the big picture, including your ongoing goals and assets. Retirement planning, after all, continues throughout your life, not just while you’re saving for it.

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