You may think a 401(k) means freedom of choice. True, it gives you the power to decide how much to save and where to invest. Like most 401(k) participants, you probably face a bewildering assortment of investment options. But no one is watching to make sure you make the right choices in order to have enough money to retire on. Most workers, in fact, are woefully in need of reliable information about how to invest their 401(k) assets. When in doubt, many choose their company’s stock, sometimes on top of the company shares they get as matching contributions. In doing so, employees and their companies are violating the three most important tenets of modern portfolio theory: diversify, diversify, diversify.
SAVE MORE–STARTING NOW
Overconcentration of 401(k)s in company stock isn’t the only problem we face. Many workers are also falling short saving for retirement now that the bull market is no longer doing the job for them. After 18 years of rising markets, during which time it was easy to accumulate assets in a 401(k) account, many savers suffered their first losses in 2000 and 2001, and now must learn to set aside more of their income. Even worse, millions of workers who are eligible to participate in a 401(k) are not doing so, either because they must take care of more immediate needs or because they think there will always be plenty of time to save for retirement.
In passing President George W. Bush’s 2001 tax-cut bill, Congress allowed workers to shelter more of their income through tax-deferred 401(k) contributions. But if employees don’t take advantage of these opportunities, especially now that the baby boom generation is nearing retirement and the Social Security system may become strapped, many could find themselves in severe financial straits in old age.
My hope is that you will avoid some of the common mistakes people have made in managing their accounts. Whether you are a rank beginner or already know the 401(k) ropes and need a refresher course, this article can help you. To make it easier to follow, the information appears in question-and-answer format.
How much can I contribute?
Under President Bush’s tax-cut legislation, passed by Congress in 2001, the contribution limit for an individual is $11,000 as of January 1, 2002. This limit will rise by 1,000 annually until reaching $15,000 in 2006. Today, the average worker’s 401(k) contribution is 8.6% of salary, according to the consulting firm, Spectrem Group.
The new tax-cut law also allows those age 50 and over to “catch up” and make extra contributions. The extra amount is $1,000 for 2002, rising to $5,000 extra in 2006, and adjusted for inflation thereafter.
The same law also requires faster vesting, shortening the early years of participation during which companies don’t allow workers to take company matching funds with them if they change jobs. Until 2002, companies could stretch the pre-vesting period to seven years, but now that period is limited to five years.
As Congress considered the tax-cut legislation, some groups expressed concern that its benefits were