Taking the Long View

How many times have you heard that investing is a marathon, not a sprint? It’s true, especially for those embarking on a run along Route 401(k).

Young professionals have a real friend in the 401(k). Described as a consistent, disciplined way to save for retirement, these employer-sponsored accounts can be a gift that keeps on giving, especially for anyone who develops a stiff upper lip in less-than-optimal economic conditions.

The benefits of a 401(k), named for the section of the tax code that governs them, start with tax advantages and compounding growth, but continue with employer matches, investment flexibility, portability in the form of rollovers, and the potential for loan and hardship withdrawals. After health benefits, this program is among the most valuable benefits that employers can use to gain an edge in recruitment and retention.

In this look at the personal bottom line, we delve into the many advantages of 401(k)s for plan participants (employees), the opportunities for employers (plan sponsors), and the responsibilities of plan administrators who believe it’s never too late or too early to start saving. 

“That said, it’s a lot easier to achieve a financially secure retirement by saving a little bit over a long period of time than it is to try saving large amounts of money in a short period of time,” said wealth advisor Ron Yee, vice president and employee benefits group manager for Johnson Bank Wealth Management. 

Tax me later

Money placed in a 401(k) is tax-deferred, both the income deferred and the compounded growth – until dispersed at retirement. Financial advisor Andrea Paff, first vice president and a member of The Droster Team at RBC Wealth Management, noted that time is an ally when compounding growth on a tax-deferred basis. “If you are in the 25% federal tax bracket, that means for every dollar you put in your 401(k), you are taking 25 cents away from the IRS and putting it back into your own pocket to grow on a tax-deferred basis over time,” she stated. 

Another advantage is that disbursements likely will be taxed at a lower rate in retirement, when income is lower than during the individual’s pre-retirement years. “As they take out that money in retirement, that’s the time at which it’s taxed, but presumably, for most people, the total income they have in retirement is less than they would be taking in before retirement,” noted Brad Mueller, a principal with CliftonLarsonAllen Wealth Advisors. “So they should be in a lower tax bracket.”

The extent to which companies match, and the range of matching options they offer, typically is defined by a single formula, a formula that every employee, executive suite or not, would be subject to. According to Mueller, a common approach would be for an employer to match the first 3% of income the employee defers; in that case, an employee who defers 5% of income would effectively place 8% into his or her account – the 5% deferred plus the 3% company match.


Todd Perala, vice president and director of relationship management for BMO Retirement Services, cited studies to show the match is linked to the level of deferral. “It’s a topic that plan sponsors need to pay attention to because they could structure that match in a way that encourages somebody to contribute more,” Perala said. “A typical match could refer to something that’s 50 cents on the dollar up to 6% of compensation. Many sponsors are saying ‘we’ll contribute 30 cents on the dollar up to 10% to encourage participants to defer a larger amount’ in order to get the full benefit of the match.”

Mueller said an employer could contribute more at its discretion if profitability dictates. In this case, everybody has to be treated equally under the law; an employer cannot give more to its highest-performing employees.

Investment flexibility is another advantage of 401(k)s. In most programs, plan participants can change the mix of investments for new contributions. For the money already invested, some plans have restrictions. For example, employees might be able to transfer money from those accounts every quarter, or several times within a quarter. Other plans are less restrictive in that they don’t limit the number of transfers during a given period, but they might be structured to limit transfers within certain investment funds. 

“What the plans typically discourage is day trading on your 401(k) account,” Mueller noted.

In each plan, there are provisions for loans or hardship withdrawals. With a loan, plan participants take a loan check and pay back the principal and interest at some future point, essentially borrowing from themselves. The downside is that money borrowed against your account is no longer invested and working for you. Moreover, if you default on the loan, the remaining balance becomes a deemed distribution from the plan and is subject to income tax plus the 10% penalty tax if it happens before age 59½.

In contrast to a loan, a hardship withdrawal is a distribution out of the plan, and would not be subject to a 10% penalty. However, there are limits to what can be distributed based on that financial hardship, and the amount withdrawn under hardship is still considered taxable income.

According to Yee, loan provisions and hardship withdrawals are optional benefits, not requirements. Given the two choices, he said the loan is a better option from a tax perspective, and with a loan, there is a mechanism to replenish your retirement account. 

It’s not unusual for companies to establish certain conditions that must be met before an employee is allowed to take a loan or withdrawal, Yee said. In most cases, companies will adopt the following hardship guidelines outlined by the IRS: 

• The purchase of a primary residence

• To prevent eviction from, or foreclosure on, your primary residence

• Payment for unreimbursed medical expenses for yourself, spouse, or dependent

• Expenses related to post-secondary education for yourself, spouse, or dependent

• Funeral expenses for an immediate family member

• Repairing damages to your primary residence as a result of a natural disaster

“Under hardship rules, you can only borrow or withdraw enough funds to cover documented financial expense,” Yee added. “In the case of a hardship withdrawal, you are suspended from making any additional 401(k) contributions for at least a six-month period. The suspension rule does not apply to loans.”

A company can establish more stringent or liberal guidelines in administering its loan program, but loans cannot exceed 50% of the participant’s account balance to a maximum of $50,000. The maximum term of a loan is five years, unless it’s for the purchase of your primary residence, and loan repayments must be made under a level amortization schedule.

The setup

In most cases, your employer (plan sponsor) sets up a 401(k) program with a plan administrator. In setting up a 401(k), the plan sponsor will arrange for participant education/enrollment meetings, at which the plan particulars are explained. The key points of emphasis include the discipline of setting money aside in each paycheck, the power of compounding returns and the company match, and the importance of diversifying your asset allocation between stocks, bonds, and fixed-income assets. 

“If you are just beginning, usually some of the more moderate allocation funds will give you a diversified approach,” Paff said. “If you have been at it for some period of time, you want to make sure that you’re reviewing your portfolio regularly in light of your overall investment objectives that you initially established.

“The second thing you want to do is make sure you have a long-term investment goal that takes into consideration your 401(k) assets. As you review investments outside of your 401(k), it’s important to make sure your diversified approach considers the specific investments within your 401(k) as well. Some folks who do not consider both run the risk of overweighting some asset classes, and underweighting others.” 

With 401(k)s, dollar-cost averaging provides the greatest bang for the buck. “As the markets go up and down, you typically buy shares of stock at different prices,” Paff explained. “Over the course of the long haul, your cost basis from buying them at cheaper dollar amounts tends to be lowered, and you can have more shares to work on your behalf when the market turns positive.”


Automatic rebalancing, which is offered by some plans, will periodically rebalance assets back to the asset allocation model because if one category is performing better than another, it will build the account faster. “The reason you allocate assets in the first place is so that you put your money in different buckets that should grow differently in different market conditions,” Perala explained. “When one segment of the economy is growing fast, that bucket is going to grow faster, but eventually that segment will be out of favor, and another segment will be in favor. 

“By automatically rebalancing, you’re capturing those gains when the market is hot and rebalancing to the original asset allocation in order to take advantage of the next market cycle.”

One recent development is the target retirement fund, which invests for people planning to retire during a certain range of years. People who are 15 years from retirement would invest in a fund in which the fund company splits money between stocks and fixed-income investments at a ratio appropriate for someone retiring in that time frame. 

Over time, they trim back the amount focused on riskier assets, typically stocks, and toward more fixed-income, or less risky, investments. At the time of retirement, a good portion of the money is focused less on risk assets and more on things that are unlikely to decline in value. 

“Those target retirement date funds are a terrific choice for people who are not particularly sophisticated investors, and who might not otherwise have a game plan in mind themselves,” Mueller explained. “It’s a great way to put your account on – I don’t want to call it auto pilot – but put it on a good track.”

With a longer time horizon, an individual can be more aggressive with asset allocation, but the typical split is 60-40 between equity and income. “If you are an aggressive investor, you can select one model; if you are a moderate investor, you can select another,” Perala explained. “If you are very risk-averse, there is a model that is more conservative. Those models will help people arrive at an appropriate asset allocation for their assets.”

A long-term consideration is that retirement years are part of the time horizon. “Many neglect to take into consideration the time in retirement as being part of the investment time horizon,” Yee noted. “In other words, you don’t invest up to retirement, you need to invest through retirement. A person that retires at age 65 has to factor in an additional 20 years as part of their investment time horizon, and also the impact of inflation over that same time period.”

Wealth management

Once the account is established, plan participants should take an active role in managing it, not simply let it sit there. That’s a big step for a lot of people who aren’t savvy investors, but self-education and professional advice can go a long way in helping plan participants make periodic adjustments.

As part of a disciplined program, participants can meet with an advisor on an annual or semi-annual basis to evaluate how their account is progressing and what adjustments have to be made. Each plan participant receives a quarterly statement that monitors the progress of various funds, and under new Employee Retirement Income Security Act (ERISA) rules, employers must include detailed information about how much plan participants pay in expenses and how well their funds are performing relative to benchmarks.

If employers fail to comply with the new requirements under ERISA Section 408(b)(2), they are subject to penalties from the Department of Labor. They also could expose themselves to legal action by plan participants, and be ordered to reimburse employees for unnecessary expenses.

One alternative is to hire a firm to act as the fiduciary to the investment advisor on the plan, delegating that responsibility and that liability to another firm. “What’s happening in the marketplace is that employers are just starting to become aware of the rules, and they are looking for places to turn,” Mueller noted. “Who can help me with evaluating those costs? What can I do to make sure I’m doing that effectively? There are firms that are helping provide benchmarking studies.”

For plan participants, it doesn’t hurt to be conversant in both investment vernacular and strategic options. With the growth of the Internet, there is no shortage of resources to help people educate themselves with some plain-English advice. Mueller is a fan of The Motley Fool website; other worthy resources are news sites like CNN Money and CNBC.

Rules of the game

Assuming they have indeed retired, plan participants can start making withdrawals from their 401(k) account at age 59½. Before that age, there are certain “qualifying events” that enable people to either roll the money from their 401(k) into an Individual Retirement Account – which, if done correctly, is a non-taxable event – or request a distribution directly from the 401(k) plan. Those who liquidate and withdraw all or a portion of their 401(k) account prior to age 59½ would not only pay the regular income tax but also a penalty of 10% on that pre-59½ withdrawal.

When changing jobs or upon termination, investors can roll over the balance of their 401(k) accounts either to a new employer’s plan or an IRA, which is subject to similar tax and withdrawal rules. They have the right to roll that balance into an IRA tax free, and they decide where and how the money is invested. An IRA can be set up with any bank, investment house, or mutual fund company.

With an IRA, there are contribution limits; the limit for 2012 is $5,000 a year. Individuals over 50 are eligible for an additional $1,000 annual catch-up contribution. “We typically advise our clients, as they leave one company and go to the next, that they are better off rolling the 401(k) balance into an IRA in their own name because they have nearly complete discretion and flexibility as to how that money is invested,” Mueller said. “With a little bit of good advice, they might come out ahead as opposed to using the new company’s plan.”

In contrast, 401(k) plans offer higher maximum annual deferral limits. In 2012, individuals can defer up to $17,000 of their earned income into their employer plans, and an additional $5,500 if they are over age 50 (for a maximum of $22,500 for 2012). 

401(k) funds also can be rolled into a Roth IRA, but the tax rules are different. “If you want to covert it to a Roth IRA, meaning that in the future your distributions would be tax-free, then you would pay tax at the time of the conversion on whatever the balance that you are rolling over,” Mueller explained. “The good news is there would not be any penalty if you took a distribution, so you would pay tax at the time you convert to the Roth IRA. From that point forward, the account would grow without a tax and you would take the distribution without a tax.”

Vested in fear

With investing, half the battle is not being frightened by market and economic volatility. “They [investors] have worked hard for their dollars, and when they see the market become volatile, they become afraid of losing their investments and tend to sell at the wrong time,” Paff noted. “A more disciplined approach can help avoid the mistake of pulling money out when markets are down, and putting it back in after the stock market has advanced.” 

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