Your Questions About 401(k) Plans

By: Jonathan D. Pond | Source: AARP.org | June 23, 2009

I am participating in a 401(k) through my employer, but the employer has suspended the match.  Should I continue making contributions or save for retirement elsewhere? –Michael, Utah

You should absolutely continue making contributions to your 401(k) plan.  While an employer match is nice, it is simply icing on the cake. An unmatched 401(k) or other workplace retirement-savings plan still offers two tremendous advantages:

• Immediate tax savings
• The opportunity to enjoy tax-free buildup of your investments in the plan until you begin making withdrawals after you retire

Here’s an example of the immediate tax savings: Say you have been contributing $10,000 annually to your plan and you’re in the 25 percent federal income-tax bracket. Those contributions will reduce your tax bill by $2,500 ($10,000 multiplied by 25 percent in taxes). Or think of it this way: If you were to forego making the $10,000 contribution to your 401(k) or other pre-tax plan, your tax bill would increase by $2,500.

Despite the advantages of contributing, though, there may be a couple of arguments for reducing your 401(k) contributions. If you are concerned about losing your job and you don’t have much in an emergency fund, you might want to build up a cushion by temporarily reducing or eliminating your 401(k) plan contributions. But be realistic in assessing your job prospects. Far more people fear unemployment than actually end up unemployed.

Some argue that a Roth IRA contribution (if you qualify) is actually better in the long run than an unmatched 401(k) or 403(b) contribution. In the best of all worlds, you would do both, but if you have to choose between the two and you can forego the immediate tax break (Roth contributions are not tax deductible), the Roth may get the nod until your employer reinstates the match.  

 I have been downsized and will have over a year of severance and benefits. I have a 401(k) and cash plan pension I would like to invest for monthly income. What do you suggest would be best way to do this without too much risk? –Ken, New York 

The response to your question depends in part upon whether you plan to retire now or expect to reenter the workforce. 

If You Are Retiring
Income is important for retirees, but so is the growth of your investments. Investing wisely in retirement requires a balancing act between investing for income in order to pay your bills and investing for growth in order to keep up with inflation over the decades. Even at today’s low inflation rates, most retirees will see their cost of living at least double over their lifetimes.

Unfortunately, interest rates on safe investments are very low now, although they rose a bit in the late spring. Therefore, you will need to take a bit of risk with your income-oriented investments if you want to earn more than a smidgen of interest on them. Here are some suggestions:

Safe investments: Safe investments are characterized by the almost absolute security that you won’t lose principal and, in most instances, immediate access to your principal. The “price” you pay for this safety is low interest, but for many beleaguered investors, that is a price worth paying these days. Safe investments include Treasury bills, CDs, money-market funds, and money-market deposit accounts. 

It often pays to shop around for safe investments, including with credit unions, because some institutions pay better interest than others.

Better interest income with some risk: Income-seeking investors can earn better returns than those offered on safe investments, but at the risk of losing some, but generally not a lot of principal. High-quality corporate and municipal bonds with short maturities are worthy contenders, as are mutual funds and exchange-traded funds that invest in short-term bonds.
 

Dividend-paying stocks: Since retirees need both income and capital growth for a secure financial future, one investment fills both bills: stocks of financially strong companies that pay dividends. Of course, even these stocks can lose a lot of value very fast, but retired investors might want to put some money into a group of these stocks or a mutual fund or exchange-traded fund that invests in dividend-paying stocks. Incidentally, the current dividend yield of the Standard & Poor’s 500 Stock Index is 2.4 percent; the yield on the Dow Jones Industrial Average stocks is 3.4 percent.

Finally, the above ideas are not meant to be “either/or” suggestions.  You should earmark some of your money toward very safe investments, such as CDs and money-market funds, despite their paltry interest. You should also direct some money into investments that offer higher income, albeit at the risk that you might lose some principal.  

Do You Plan to Continue Working?
The above suggestions can also play a role in the investments of someone who is still in the workforce. But as an employed person, earning income from your investments is less important, since your wages or salary should provide all or most of your income needs.

Therefore, your approach to investing should probably place more emphasis on growth than on income. However, all investors need to have a good portion of their money invested in lower-risk, interest-paying securities, whether the markets are thriving or diving.    

My wife and I retired a year ago; I have a question about my 401(k) plan and IRAs. Is there any advantage to leaving these accounts alone until I reach 70 ½, or should I be taking a monthly withdrawal now? I seem to be able to make ends meet without doing so.  –Peter, Pennsylvania

You’re in an enviable position to be retired and not yet needing to tap into your 401(k) and IRAs. Here are my thoughts:

1. Your 401(k) : You might want to consider closing out your 401(k) account and rolling it over into your IRA, unless your former employer offered a wonderful 401(k). Most workplace retirement-savings plans offer limited choices, and some of the choices are mediocre at best. By moving the 401(k) to an IRA, you’ll be able to choose from among a much greater number of investments and will have better choices.

2. Postponing your withdrawals: In most situations, it is better to delay cashing in your benefits as long as possible. Also, once you’re required to take minimum distributions, you are well advised to stretch them out as long as possible. Here’s why: First, distributions from retirement plans are entirely or mostly taxable.  So you have to withdraw more money from a retirement plan compared with the savings you have outside retirement plans to have enough left over after taxes are taken out to pay your bills. 

For example, if you needed $10,000, you could simply withdraw that amount from a savings account or, perhaps, a maturing CD and have $10,000 in hand. But if you were to take the money out of a retirement plan, you’d probably need to withdraw around $13,000, because about $3,000 in taxes will have to be paid. A second reason it pays to delay retirement-plan withdrawals is that it gives the money more time to grow tax-free. Now you may argue that the retirement money is likely to shrink, rather than grow in the future, given the sorry state of the economy. But if you can wait several years or more to withdraw retirement-plan money, chances are pretty good that you’ll enjoy some nice growth from your investments. After all, stocks have been beaten way down, so it should pay to wait to make withdrawals.

3.  An exception to the rule: When you might benefit from taking retirement-plan distributions sooner rather than later.

You may want to make some withdrawals now, even though you don’t need to (assuming you’re over age 59½). If you find that your taxable income is quite low, you should take advantage of your modest tax bracket to withdraw enough money to have those withdrawals taxed at a low rate. Many recent retirees expect to be in the 25 percent or higher tax bracket once they have to make minimum IRA distributions, but they now find themselves in the 15 percent tax bracket, because they, like you, are living off savings, CDs, and other non-retirement investments. If this describes your situation, you should consider withdrawing enough money from your IRA or other retirement plan to have it taxed at 15 percent, rather than waiting until later years, when it will be taxed at 25 percent. Remember, in 2009, taxable income below $34,000 is generally taxed at 15 percent or less for singles and $68,000 for married couples filing jointly.
 
My husband is in his 60s and I’m in my 50s. We are both retired. Where should we put money that we definitely won't need for the next eight to 12 years? We have most of our money in stocks and bonds and one CD, which will be due later this year.  –Laurette, Washington

The way you should invest depends on two factors:  when you’re going to start tapping into the money and how long it will need to last.

 In your circumstances, you won’t need the money for a decade, and, given your relatively tender years (relative to me, at least), you’ll need the money to last for another three decades. So your “investment horizon” is a whopping four decades. To their possible financial detriment, many people who are nearing retirement or are retired already don’t take their investment horizons into consideration.

You indicate that you have most of your money in stocks and bonds, and that’s where your long-term money should reside. But the $64,000 question is this: How much do you have in each category? Let me give you some guidelines that are strictly my own. I will be so bold as to suggest that the percentage of money that you allocate to stocks should comprise no less than 40 percent of the total you have earmarked for retirement and probably not much more than 60 percent—unless you can tolerate losing a sizeable portion of your money, as has happened over the past year to stock devotees.

In the final analysis, you have to be able to sleep at night.  If holding a good dollop of stocks is robbing you of sleep, then lighten up. But keep in mind that the way the investment markets perform over the next few years, even over the next decade, should not be an overriding concern of those who will need the money to last for several decades. Taking little or no risk with all or most of your money could result in your having to cut back on your living expenses later in life.

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