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Plug the holes in your 401(k)
These retirement plans are great, but they don't offer the kind of diversification -- into real estate or short funds, for example -- you really need. Here's how you can fix that.
By Timothy Middleton
If the wheels came off your 401(k) plan in the bear market, maybe the pit crew shares some of the blame with the driver.
Most plans are designed for Sunday drivers, not the Nascar-quick breed that was able to prosper in the last three years. Traditional plans have an array of me-too equity and bond funds, but the most successful investments lately -- precious metals and other commodities, real estate, foreign-government bonds and shorting strategies -- are absent.
The plan sponsor doesnt want his employees buying short funds, losing a whole lot of money and coming back to sue the sponsor, says Tom Grzymala, president of Alexandria Financial Associates in Virginia. So they are prone to go with a large-cap value fund, and another large-cap value fund, and a bond fund.
That isnt enough to diversify thoroughly, which means the typical 401(k) isnt a one-stop retirement solution. Fortunately, there are alternatives. Garden-variety IRAs can be the perfect supplement. Roths can be smarter still, and, in some circumstances, taxable brokerage accounts smartest of all.
Taking those steps can be a bit clumsy, however. A few tweaks of pension laws would ease them considerably, but dont hold your breath: The prime lobbyist for pension matters, the AARP, dismisses them as loopholes for the rich that would be dangerous for ordinary Americans.
Still, you can take a holistic approach to your retirement investments by combining the best of all the options, whether they're 401(k)s, Roth IRAs or traditional IRAs.
Don't forgo free money
401(k) plans have become the nations nest egg of choice. More Americans (30%) expect them to be their primary source of income in retirement than company pensions (14%), private savings (also 14%), Social Security (13%) or anything else, according to the Employee Benefit Research Institute.
The Economic Growth and Tax Relief Reconciliation Act of 2001 increased contribution limits, making 401(k)s even more attractive. For 2003, you can contribute $12,000, and workers over 50 are allowed to contribute up to $2,000 more than that.
A majority of plans also offer an employer match, which most commonly is equal to 50% of the employees contribution, up to 3% of his or her pay. This is free money, which youd be a fool to turn down.
The first thing you do is get every employer dollar you can, says Jim Jaffe, the benefit institutes spokesman. Its almost impossible to get a return equal to that employer money on anything else.
Virtually every 401(k) has sufficient options to allow you to create the core of your investment portfolio. Fidelity Institutional Retirement Services says the average plan offers a dozen investments. Roughly half are domestic stock funds, and the rest are high-quality bond and balanced funds, supplemented by an international equity fund, a stable-value portfolio and a money market.
Beyond the 401(k)
These are solid investments, and I would put 70% or so of my nest egg in them. But diversifiers are important, too, and to get access, most people need to go outside their plan and into some kind of brokerage account. Only 9% of large K plans, and 2% of small-company plans, offer a self-directed brokerage option, Fidelity says.
Fortunately, taking that step isnt too hard. Open an IRA, says Jon Coppola, a financial adviser with Waddell & Reed Financial Services in Morristown, N.J. Married taxpayers with adjusted gross incomes (for tax purposes) of less than $150,000 can open Roth IRAs, and those with incomes below $60,000 can open the tax-deductible version. Contribution limits in each have been raised to $3,000. Dont forget: Take this step only after youve claimed the maximum employer match in your 401(k).
Rollover IRAs are another possibility. If you have money left in a K plan from a previous employer, have it transferred into a brokerage-sponsored IRA that allows you to invest in the whole panoply of securities available these days, from individual stocks to exotic mutual funds.
In addition, many K plans allow what are called in-service distributions. These can be redirected into a rollover IRA without paying taxes. Not all plans permit this option, but all of them can.
This is neither mandated nor disallowed by law, says Morris Armstrong, principal of an eponymous financial advisory firm in New Milford, Conn. That option ought to be given, so you can select from a broader universe.
Check with your human resources department. If your plan doesnt provide for these distributions, talk to the boss: All thats required is amending plan documents. The cost of doing that is small.
Tax-savvy strategies
The combination of a 401(k) and an IRA will allow you to optimize most retirement investments. Their tax-deferred nature makes them ideal for owning income-producing securities. Proceeds from these so-called qualified retirement plans are taxed as ordinary income, and so are dividends on income funds.
Assuming your 401(k) plan offers only high-quality bond funds, own them in this account, and use the IRA for real-estate funds and junk and foreign-government bond funds. Equity funds that produce an income stream, such as equity-income funds and value funds, likewise do best in these plans and are usually available in 401(k)s.
Conventional IRAs aren't the best place, however, to hold equities that dont pay dividends. In an ideal portfolio, you will own growth stocks and growth-stock funds in a taxable brokerage account.
There are two reasons, and both involve taxes. The first is that the maximum tax rate on capital gains is half that of the rate on earned income. Investments inside a 401(k) or an IRA, however, dont qualify for that rate; when withdrawn, they're taxed as income.
(A Roth IRA is better still; you dont pay capital gains within the account or anything upon withdrawal.)
The second is that, when you end up with losses -- and who doesnt -- they dont do you any good in a tax-deferred account. You cant deduct them because they exist outside the reach of taxes.
In a taxable account, however, they can be deducted fully, first against investment gains, and then against ordinary income, at the rate of $3,000 annually. If your losses are more than that, you can carry them forward as long as it takes to utilize them; they never expire.
Taxable accounts, therefore, are great for extremely volatile investments, such as sector and emerging markets stock funds, as well as opportunistic or risky bets, such as the short-only Grizzly Short Fund (GRZZX) or commodity funds such as Oppenheimer Real Asset (QRAAX).
When all these accounts are put together, they might look like this:
| Moderate-risk portfolio | | Investment | 401(k) | IRA | Taxable | | Value stock funds | 30% | | | | Growth stock funds | 20% | | 10% | | Foreign stock funds* | 10% | | | | Sector funds | | | 5% | | High-quality bonds | 10% | | | | Junk bonds | | 5% | | | Foreign-govt. bonds | | 5% | | | Real estate, other** | | 5% | | | TOTALS | 70% | 15% | 15% |
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Notes: *If 401(k) allows; otherwise own in taxable account.
**Precious metals, commodities, short-only portfolios, cash, etc.
Be your own advocate
The final step you can take to optimize your retirement portfolio is to badger the authorities to spare you all this effort and create more flexible 401(k) plans. President Bush and the Republican majority in Congress have put that on the agenda. The president wants to eliminate IRA income limitations, for example, which he says disqualify half of all households.
But nobody is pushing to mandate that plans provide for in-service distributions or a self-directed brokerage option. Indeed, the AARP is against both ideas.
David Certner, the groups director of federal affairs, says each of them appeals to only a wealthy minority of plan participants. The self-directed brokerage option is only demanded by certain types of workforces at this point, maybe your higher-income law firm, for example, he says. For others, Im not sure its appropriate.
Rather than being concerned participants will take advantage of rollovers to open flexible IRAs, moreover, he says AARP is more concerned the money will simply be spent, which argues for tougher rules, not more liberal ones.
Amid this class warfare, therefore, dont expect Washington to do you any favors. But your boss is a capitalist, and therefore more disposed to streamline the plan; lean on him. Meanwhile, fend for yourself; its doable.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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