by Jeff Reeves | June 12, 2012 12:16 pm
We all know the biggest risk to investment accounts is performance. If the market tanks, any stock-based mutual fund in your 401k account will decline sharply, too. If bond yields remain paltry, any bond funds you own will perform poorly, too. That’s the way investing works.
But retirement investing strategies that focus only on performance also can lose you a significant amount of money — even in Wall Street’s good times.
That’s because attention to fees and logistics of your 401k or IRA plan can be just as important as picking the right places to put your money. And investors who don’t read the fine print or perform regular portfolio maintenance can see their retirement account languish, even if they have the right funds picked out.
So how do you avoid this fate?
Start by avoiding these five hidden ways your 401k plan could be leaking cash.
Start by making sure you are taking advantage of the full match your employer offers. It’s free money — as long as you take the initiative to ask for it.
The rules differ for every employer, but the bottom line is to take what’s offered. If your company offers 100% on the first 3% of your pay you contribute, set aside 3%. If your company offers a 50% match on the first 6%, take all 6%.
You might be reluctant to “reduce your salary,” but this is the wrong way of thinking. In truth, you actually are giving yourself a raise. Yes, if you make $50,000 annually, a 6% contribution moves $3,000 of spending money each year into your 401k. But don’t forget that your employer will be giving you an extra $1,500 above your salary with that aforementioned 50% match.
You have to save for retirement anyway, so why say no to an extra $1,500?
The most obvious charges that 401k investors have to endure are the “expense ratios” of their mutual funds. You might have seen these on your portfolio’s documents and just shrugged them off. After wall, what’s the big deal about a 1% fee?
If you think that way, it’s time to change your mind-set — and in a hurry, because little fees add up fast. In real terms, that 1% fee is what is shaved off your 401k account for each year.
Let’s look at a practical example. Say you are investing $3,000 per year in your 401k and average a roughly 5% annual return. In 30 years, you’ll have a nest egg of about $210,000 with compound interest. But if you have to give up just half a percentage point and average only 4.5% annual returns, the final amount in 30 years will be just more than $190,000. That’s $20,000 less, or almost 10% shaved off the final amount!
So if you think your expense ratio doesn’t matter, think again.
Expense ratios are the easiest thing to watch, but don’t think that’s the end of the story. Responsible investors need to do a bit of detective work if they want to know the whole story about what they are paying for.
Most companies have to report fees and expenses of their employee benefit plans by law, unless they are of a very small size. This commonly is done on the “transaction history” or similarly labeled section of your regular 401k statements. If you see a small dollar amount withdrawn or partial shares taken out, you can bet an administrative fee is the culprit.
If you can’t find any fees in the transaction history on your account statement, your human resources department should be able to get you an ERISA filing — short for Employee Retirement Income Security Act. This law requires fees to be logged in some manner, and they should point you in the right direction.
Sometimes the fees are baffling, including varying in size based on the amount of money in your account. And sadly, there are some administrative fees you just can’t avoid because employers only offer one 401k provider. However, it’s important to know what you’re paying — because if the fees are steep, it might be in your best interest to consider alternatives to simply relying on 401k investing alone.
The practice of “rebalancing” your 401k is tricky because it involves assessing how your portfolio has changed over time and moving the money around to best suit your retirement goals. Because of how different mutual funds perform, your 401k might get top-heavy without you even noticing.
Think of it this way: You have $10,000 in a fast-moving stock fund, and $10,000 in a low-risk bond fund. Your goal is to be allocated 50-50 between the two. Well, if the bond market is flat and your stock fund goes up 50%, you now have $15,000 in stocks and $10,000 in bonds. You’re now 60-40.
So what do you do? You rebalance. Take $2,500 out of your stock fund and transfer it into bonds so you can return to a 50-50 mix.
This is a key part of risk management, because over time you might not notice that the lion’s share of your portfolio is in risky, fast-moving investments. It’s a good problem to have, of course, that one part of your portfolio has grown so fast. But if you don’t move that money around, you could expose yourself to disaster if things turn the other way.
There’s a catch, though: Some 401k plans don’t let you constantly move around your money and have a cap on the number of transfers you can perform annually. If you exceed that amount, you might have to pay a fee. So while rebalancing is important, don’t overdo it.
A good rule of thumb is to simply rebalance once a year at tax time, with the help of your accountant or financial adviser if you have one.
The hard reality of the current economic environment is that many people have had to tap into their retirement savings to make ends meet. But this should be an absolute last resort.
For starters, if you withdraw money before retirement, it not only will be taxed, but you’ll absorb a 10% early-withdrawal penalty. So all that hard work you put in to save will be offset by steep charges simply for taking that money out early.
Also, it’s not just a question of simple math. Removing $10,000 now cuts much more than $10,000 out of your total nest egg. A 5% average return annually will turn that $10,000 into over $16,000 in just 10 years. Presuming your 401k performance is good, you are forfeiting the potential profits you’ll generate with this investment in addition to the principle.
Never take a loan from your 401k plan or cash out early if it can at all be avoided. Depending on your circumstances, it actually might make more sense to put a few thousand bucks on a credit card or take out a home equity loan than to eat into your nest egg.
So think things through before raiding your retirement. The penalties are steep.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.
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