How to play catch-up

You might need to revamp your retirement savings strategy in light of investment losses and employer cutbacks

Time travel sounds like fun unless you’re talking about retirement accounts. With our 401(k), 403(b), and IRA balances back to where they were in 2003, lots of us are wondering how we can ever catch up.

Employer-sponsored retirement plans lost an average of 19.1 percent of their value, or $573 billion, last year, according to the Employee Benefit Research Institute. Fidelity recently reported that its average 401(k) participant lost 27 percent, down to $50,200 from $69,200.

Meanwhile, numerous big companies, including General Motors, Kodak, Motorola, UPS, and Wynn Resorts, have suspended their 401(k) matching contributions, which make these tax-deferred accounts so attractive to employees. Benefit-consulting firms are reporting closures of 401(k) plans among some smaller employers, according to The Wall Street Journal.

Regardless of your age, the blow to your savings calls for a reassessment. Should you keep contributing to your 401(k) without an employer match? What if your employer pays the match in company stock? How much money should go into an IRA instead? Is it worth contributing more to an account that could decline further? Below, we offer some common problems and potential solutions.

Is my 401(k) still worth funding without an employer match?

Many employers match as much as 3 percent of workers’ 401(k) contributions, or 50 cents per dollar, on up to 6 percent of gross pay. If that goes away, some financial advisers say, there’s not much incentive to keep investing in your company’s plan.

Matt Conrad, a CPA and managing director of Complete Wealth Management in Mission Viejo, Calif., notes that 401(k) plans don’t provide the range of investments that you could get with an IRA. And 401(k) investments, particularly those in small to midsized plans, can have high expense ratios—fund-speak for management fees—that eat into returns.

Instead, Conrad suggests investing outside your company’s retirement plan, first in a Roth IRA—if your income qualifies you—and then in your 401(k). You’re entitled to contribute up to $5,000 in a Roth, plus another $1,000 if you’re 50 or over (see How long will it take?). A Roth IRA is funded with after-tax income, but your gains and withdrawals are tax-free. “Long term, the tax benefits are greater with a Roth,” Conrad says.

But not everyone agrees with Conrad’s strategy. Other advisers say that even without the match, 401(k) plans are still worthy of your contributions up to the maximum allowable: $16,500 for 2009, plus another $5,500 if you’re 50 or older. If you can, make up for that missing match by replacing it with your own money. “If you’re lucky enough to get a raise, dump as much of that as you can into the 401(k),” says Michael Kresh, a certified financial planner and principal of M.D. Kresh Financial Services in Islandia, N.Y.

Higher-paid workers might have no choice but to stick with a 401(k), which unlike a Roth IRA has no income ceiling. Lower-paid workers, whose tax rates are less than the maximum—say, 15 percent vs. 35 percent—might benefit more from putting after-tax money directly into a Roth IRA, because the deductibility of 401(k) contributions is a smaller tax break than the free tax ride a Roth offers. But if your tax and income situation allows you to go either way, consider these factors:

• Where are costs lower?
  High investment costs will depress your returns. But larger employers sometimes offer expense ratios that are hard to beat outside a 401(k). The Vanguard S&P 500 Index fund (VFINX) has an expense ratio of 0.15 percent; that is, you’d pay about $1.50 a year in fees for every $1,000 invested, which is already pretty reasonable. But Vanguard’s Signal shares of the same investment (VIFSX), sold through large-company 401(k)s, carries an even better 0.07 percent expense ratio.
  
  
• How important is choice to you?
  You might not find real-estate investment trusts and exotic sector funds available in your 401(k). But the very fact that 401(k)s aren’t investment supermarkets may make them better suited to the average investor, says Jack VanDerhei, research director of the Employee Benefit Research Institute in Washington, D.C. He points to studies that have found that individual investors, faced with too many investment options, can become overwhelmed. “If you give people info overload, you freeze them into inactivity,” VanDerhei says.
  
  
• Can you borrow from the fund in an emergency?
  While it’s not recommended, you might have that option with a 401(k), but not with an IRA (though folks 59½ and older can take tax-free withdrawals from a Roth IRA after five years of starting it). Terms vary from employer to employer, but generally you’re entitled to borrow half of your 401(k) holdings, up to $50,000, without penalty. With few exceptions, if you don’t pay the loan back before you leave the employer, the remaining balance is treated as a withdrawal, taxed at your ordinary income tax rate and possibly penalized for early withdrawal.
  
  
• How easy is it to set things up?
  Establishing a 401(k) with your employer is relatively easy: Simply fill out a form or two at work. Setting up an IRA might be just as easy, and you can have your contributions automatically transferred from your bank or paycheck.
  
  “If you’re not going through the 401(k), you have to make sure you go out and open up those IRAs and Roths and get those contributions in,” says Michael Palazzolo, a CPA and certified financial planner at Access Wealth Planning in Roseland, N.J. “I see people procrastinating all the time.”

I’m leaving my job. Should I roll over my 401(k) money or keep it with my old employer?

If your balance is less than $5,000, your old employer doesn’t have to maintain your account in its 401(k) plan, so you’ll probably have no choice but to cash it out or roll it over into an IRA. If your account is larger than that, your decision should hinge on the quality of the plan. 

If you’re moving to a new job, you might be able to roll your money directly into that company’s plan. Once again, compare the costs and investment options of the two plans.

Should you decide to roll over your 401(k) money, arrange to have it sent to the investment company handling the account, not to yourself.

If your adjusted gross income is $100,000 or less, you can make a direct rollover from a 401(k) or 403(b) plan to a Roth IRA. If you do so, though, you’ll have to pay ordinary income tax on any of the money that has not yet been taxed.

My company is dumping its 401(k) plan. What should I do?

This is still uncommon but can happen. The good news is that all your holdings become 100 percent vested, meaning that you’re entitled to the full amount that your company has contributed on your behalf. But you must roll over your account within the prescribed 60-day period to avoid paying income tax on the distribution and, if you’re 59½ or younger, to avoid a penalty.

Is a 401(k) worth it if the match is made in company stock?

A match in company stock—a common practice—often isn’t ideal, but it’s better than no employer match. Investing a substantial portion of your wealth in the same place you work is always risky—just ask former Enron employees, who lost their jobs and their shirts when the company foundered. In the past, company stock was the only option for many 401(k) participants. But after the Enron debacle, the IRS ruled that employees can trade out of their company stock after three years. Some employers let you do it sooner.

My 401(k) balance is way down. Why should I keep investing in stocks?

If you have a long time horizon—five years or more—you should stay invested and continue to contribute to your stock holdings. For one thing, locking in losses by selling now isn’t wise. For another, stocks are at a significant discount and may never be so cheap again. “We’ve got a 50 percent sale in stocks going on,” notes Richard S. Kahler, a fee-only financial planner in Rapid City, S.D.

And while no one knows when a turnaround might occur, Dalbar, an investment research company, has found that major market rises tend to happen within just a few days, before most investors have time to react. If you don’t want to miss out, it’s best to stay invested.

Should I change my ratio of stocks to bonds?

If your allocation between stocks and bonds was based on your age, tolerance for risk, and time until retirement, stick to those parameters. Ostensibly, your initial allocation was based on a plan that’s worth continuing. Rebalance by selling holdings that have gone beyond the percentage where they should be and buying more of what’s shrunk in your portfolio.

If, however, you’ve discovered your tolerance for risk is not as great as you thought, you might have to change your allocation to reflect that. Keep in mind that less risk in your portfolio might mean lower returns over time. So you might need to work longer and contribute more each year to get back to that future you’d envisioned in 2003.

This article appeared in the April 2009 issue of Consumer Reports Money Adviser.