35 years ago, corporate benefits consultant Ted Benna was helping a company change its employee bonus plan into a deferred profit-sharing plan. Knowing it wouldn't be well received by employees, he scoured the tax code, looking for ideas. He found part of what he was looking for in an obscure provision of the code — Section 401(k) appeared to allow workers to set aside a portion of their salary on a pre-tax basis. He knew that alone couldn't compete with a cash bonus, so he came up with another incentive — a company match.

From those humble beginnings, the 401(k) has grown into the most popular workplace retirement program, with some 60 million workers now participating.

Workplace retirement plans have an image problem. Such plans, including 401(k) and 403(b) plans, come under regular media criticism for their fees, complexity, and perhaps most of all, their inability to provide guaranteed retirement income. Many workers, it seems, long for the good old days when employers provided pensions that required little in the way of investment knowledge and provided a reliable retirement income stream to go with their gold watch.

So deep is the desire to go back to the days of defined-benefit pension plans that a recent national survey of over 5,000 full-time employees, conducted by workplace consulting firm Towers Watson, found 62% willing to give up some pay in exchange for guaranteed retirement income.

However, rearview mirrors provide famously distorted views. Consider research from the Employee Benefit Research Institute (EBRI), which found that even as far back as 35 years ago, less than 40% of private-sector workers were covered by a traditional pension. "Even in the 'good old days' when 'everybody' supposedly had a pension, the reality is that most workers in the private sector did not,"says Nevin Adams of EBRI's Center for Research on Retirement Income. "Even among those who did work for an employer that offered a pension, most in the private sector weren't working long enough with a single employer to accumulate the service levels you need for a full pension."

Today, of course, even fewer workers — just 14% as of 2011 — are covered by a traditional pension.

In its place is the 401(k). (For the most part, when this article refers to a 401(k) or workplace plan, those terms are meant to refer to 403(b) plans as well. 403(b)s are available to many employees of tax-exempt organizations, such as schools, charities, and government agencies.) Named for a section of the tax code, the 401(k) was born in 1980, and its popularity grew rapidly. Today, nearly 80% of full-time workers have access to these defined-contribution (not defined-benefit) plans, according to the U.S. Bureau of Labor Statistics. Companies prefer them because 1) they are less costly, and 2) they shift the investment risk to employees.

While such workplace plans do require more knowledge and active involvement by participants than traditional pensions, they also provide some compelling benefits, such as the opportunity to save a significant portion of one's income in a tax-advantaged way, and in many plans, matching contributions from the participant's employer. Here's what you need to know to make the most of your workplace plan.

1. Participate

To benefit from your workplace plan, you have to participate. That may seem obvious, yet many people who could participate do not. According to Fidelity, the largest administrator of 401(k) plans, almost one-third of workers eligible for a 401(k) plan are not participating. Asked why they take a pass, many non-participants say they can't afford to contribute. But saving even a small percentage of your salary is better than nothing, and if your employer will match some of what you contribute, that's free money. Especially when matching is involved, you can't afford not to participate.

That said, there are some situations when even we recommend taking a pass, at least temporarily. It's best to be out of debt (with the possible exception of a reasonable mortgage) and to have an emergency savings fund totaling three-to-six months' worth of essential living expenses before signing up for your workplace plan. Otherwise, when you experience one of those unexpected financial emergencies we all experience from time to time, you may have to raid your retirement funds, possibly incurring an added tax bill and penalty as well.

If you can put money toward getting out of debt and building an emergency fund each month while also investing enough through your workplace plan to get the full — or even partial — match, that would be ideal. If you can't afford to do all three, focus on getting out of debt and building savings before opting in to the retirement plan.

Beware that even when you're ready to participate, your employer may make you wait. A Vanguard analysis of 2,000 plans found that only 54% offer immediate eligibility. About 15% have a one-year waiting period.

At other workplaces, you don't even have to choose to sign up. To get more people saving for their later years, an increasing number of companies are making participation automatic, though not mandatory. If you don't want to participate, you have to opt out, rather opt in. Today, 26% of companies use auto-enrollment, up from 17% five years ago. Among the largest employers, that figure jumps to 52%.

Auto-enrollment programs have proven effective in getting more workers to participate and to stick with their plan, but there are also downsides. Fidelity's research shows those enrolled automatically tend to contribute less than those who sign up on their own, due to the low default contribution rate used by many plans. Almost 75% of companies that use auto-enrollment start worker contributions at 3% of salary or less, and most employees never increase their contribution rate.

To combat that, some employers give workers the option to choose automatic annual increases in their contribution rate, typically one percentage point per year up to a maximum of 15% of salary. This is an excellent way to boost long-term savings.

2. Get the match

If you are eligible for an employer match, contribute at least as much as is needed to get the full match. It's the easiest money you'll ever make. In a typical arrangement, your employer may match your contributions 50 cents on the dollar up to a maximum of 6% of your salary. Let's say you make $50,000 per year. To contribute in a way that gets you the maximum match, you would contribute $3,000 per year (6% of your salary). In return, your company will kick in $1,500 (50 cents for every dollar you contributed). That's a guaranteed 50% return on your money!

Let's look more closely at just how powerful a benefit this is. Sticking with our example of a $50,000 salary and a 6% contribution, beginning at age 20, if you earn an average annual return of 7% on that money and if your salary increases 3% per year, your balance will be roughly $1,950,000 by age 70. That's impressive by itself. And yet, that's without a match. Now let's add a match of 50 cents on the dollar up to 6% of salary. By age 70, you'd end up with nearly $1 million more!

Depending on your age and salary, you likely will need to save more than 6% of your salary in order to meet your retirement funding goal. Regardless, an employer match will help you reach your goal much more quickly.

3. Determine how much you need to save

In 2014, 401(k) participants are allowed to contribute up to the federal cap of $17,500, and another $5,500 for those 50 and older.

At the end of the first quarter of 2014, the average 401(k) balance stood at $88,600, according to Fidelity. However, averages can be deceiving since a small number of participants with large balances can skew the average upward. Fidelity says the median (the midpoint of all accounts) balance in a 401(k) account at the end of the first quarter of 2014 was just $24,400. For those older than 55, the median was $65,300.

To estimate how much you'll need for retirement and how much you need to save each month to get there, start with one of the free online calculators that are readily available.

4. Make an informed tax choice

About half of employers with a workplace retirement plan now offer both a "traditional" 401(k) and a Roth 401(k), according to a survey by benefits consultant Aon Hewitt. Employees can choose one or the other. Or, in many cases, employers now allow workers to participate in both.

With a traditional 401(k), your contributions are made pre-tax. That means every dollar you contribute to your plan reduces your taxable income by a dollar. If your salary is $80,000 per year and you contribute $10,000 to your plan, your taxable income for the year is reduced by $10,000. But the tax bill isn't torn up; it's deferred. When you take money out of the plan in retirement, you'll need to pay ordinary income tax on your contributions as well as all of your investment gains.

With a Roth 401(k), that scenario is reversed. You receive no immediate tax benefit on the dollars you contribute to the plan. However, when you take withdrawals from the account in retirement, your contributions and earnings will be tax-free. (Any employer matching funds are taxed, even if made to a Roth 401(k).)

Deciding whether a traditional or a Roth 401(k) is best for you generally comes down to a comparison between your current tax rate and what you expect it will be when you retire. If you're in the early stages of your career and your salary is relatively low, a Roth likely will be better. Your current tax bracket is likely to be lower today than it will be when you're older. If you're in a high tax bracket today and expect it to be lower in retirement, you will likely be better off using a traditional 401(k). (See Traditional IRA vs. Roth: Which Maximizes Retirement Income?)

If your tax situation is unclear and your plan provides the option, it may be wise to split your contributions between the traditional and Roth 401(k), providing some tax diversification.

With either type, make sure you don't withdraw the money prior to age 59½ (we'll discuss loans in a minute). Otherwise, you'll be subject to income taxes (with a Roth, only your earnings are subject to taxes) and a 10% IRS penalty. Both types also require that minimum distributions begin by age 70½. This is one important way a Roth 401(k) differs from a Roth IRA. With a Roth IRA, there are no mandatory distributions.

5. Coordinate your workplace plan with an IRA

What if your employer provides a match but doesn't have many investment choices? In that case, you should contribute enough to take full advantage of the match, but then open an Individual Retirement Account (IRA) to continue your saving. You will be faced with the same traditional vs. Roth decision you may have dealt with in your 401(k). You'll also be limited in the amount you can contribute (currently $5,500 per year, and another $1,000 if you are 50 or older) and possibly also restricted by your income. Eligibility to make tax-deductible contributions to a traditional IRA, or to contribute at all to a Roth, phases out at higher income levels. (See Making Sense of Your IRA Options.)

SMI's recommendation for funding priority is as follows. First, take full advantage of the match at your workplace plan. Then, fully fund an IRA (or two IRAs, if married). At that point, if you still need to save more to hit your retirement funding target, go back to your 401(k) and contribute more there. Eliminating the IRAs and keeping all your money in the 401(k) may simplify your retirement savings a bit, but unless you have a "brokerage window" (see below) in your company plan, an IRA is likely to give you greater flexibility and the ability to invest exactly the way you want to.

What if your plan doesn't offer a match? In that case, start with an IRA first and only contribute to your company plan after fully funding your IRA(s).

One final note about company matches: be sure to understand your company's rules. Some companies provide their match just once a year and you need to be on the payroll at that time in order to be eligible. Some also have vesting rules that restrict your ownership of the matching funds based on your years of service.

6. Choose the right investments

Today, the average 401(k) plan offers 19 investment choices. A small but growing number of plans also offer a brokerage window, which opens up many more investment choices and is a great aid in implementing SMI's investing strategies within your company plan. A brokerage window gives you access to many, if not all, of the investment options offered by a broker such as Fidelity, Vanguard, or Schwab. Fidelity's brokerage window, for example, is called BrokerageLink.

Choosing the best investments within your plan will largely boil down to what options are available to you. Do you have enough options to build an optimum, diversified portfolio? If you have a brokerage window, you do. Either way, SMI members looking for an investment approach tailored to their unique situation and goals should be able to use one or more of SMI's most popular strategies to manage the investments in their workplace plan.

  • Just-the-Basics
    This strategy is designed optimally to be used with Vanguard ETFs or index funds, so if your plan includes Vanguard funds (or a Vanguard brokerage window), this strategy will be easy to follow. If your plan doesn't use Vanguard funds, this is one case where substituting similar index funds or ETFs from another family can normally be done without any problem.
     
  • Fund Upgrading
    Access to a brokerage window provides the best way to utilize this strategy. But the SMI Personal Portfolio Tracker enables plan participants without broker windows to use a simplified version of Upgrading that has produced great returns for many retirement savers over the years. (See Using the SMI Personal Portfolio Tracker to Manage Your Retirement Plan.)
     
  • Dynamic Asset Allocation
    DAA is best implemented through a brokerage window, ideally one that allows you to invest in ETFs (about 75% of the Fidelity 401(k) plans that offer a brokerage window allow for ETF investing).

    Still, DAA can be at least partially implemented within many plans, providing that a plan offers good options in each of the six asset classes the strategy utilizes. (See the comments section of DAA – May 2014 Update.) Most plans offer good index fund options for U.S. Stocks, Foreign Stocks, and Bonds, as well as a money market or cash option. That leaves Real Estate and Gold as the wild cards that your plan may or may not include. If not, you can try to use another account for those holdings when called for (for example, an IRA account).
     
  • Sector Rotation
    This optional add-on strategy typically requires access to a Fidelity brokerage window.

A quick note on target-date funds, which have become a popular default choice for workplace plans. These funds offer some compelling benefits, but they also come with some significant warnings.

With a target-date fund, you choose a fund named with the approximate year of your anticipated retirement. For example, a 40-year-old who intends to retire in 30 years might choose the Fidelity Freedom 2045 Fund (that date being roughly the desired retirement date). Target-date funds provide a pre-set asset allocation that the managing fund company believes is appropriate for the targeted retirement date, and which the fund company changes automatically over time. For example, a 2045 fund, with its relatively long time horizon, would be heavily invested in stocks at this point, but would become more conservative over time, adding more bonds and reducing its stock allocation.

But all target-date funds are not created equal. One company's asset allocation for its 2045 fund may be quite different from another company's fund with the same target date, which can lead to very different results. In one stark example, right after the financial crisis of 2008, some target-date 2010 funds incurred relatively minor losses of -3.5% whereas others fell more than -41%! And those were funds designed for people right on the cusp of retirement.

7. Understand your plan's fees

A frequent criticism of 401(k) plans has to do with their fees. Some say the fees are too high; others add that the fees are difficult for employees to understand. There are two main types of fees: those related to the expense of running the plan and those charged by the mutual funds available to plan participants.

Research shows that more administrative fees are indeed being shifted to employees. In 2009, employers paid 18% of the expense of running their 401(k) plans, employees shouldered 78%, and plans covered the remaining 4%. Just two years later, the balance tipped even further, with employers covering just 5% of the fees and employees picking up 91%.

The most common mutual fund fee is a fund's "expense ratio," which covers the fund's operating, and in some cases, marketing expenses. For example, in a fund with an expense ratio of 0.50%, one-half of one percent is subtracted from the fund's earnings. Importantly, any time you see published performance numbers, these expenses have already been accounted for.

Comparing fees can be helpful when choosing between two funds with comparable investment objectives. However, don't sacrifice proper asset allocation for the sake of building a portfolio with the absolute lowest fees.

It's possible that some funds in your plan also charge a "load," or sales commission. There is no reason you should have to pay this fee, so avoid using load funds.

Workplace plans are now required to make fees more transparent. A 2012 Labor Department rule mandated new disclosure forms. Still, critics say the forms are confusing, and a 2013 EBRI study found that only about half of workers say they have even noticed the information.

Another way to assess your plan's fees is to visit the Brightscope website. This company rates plans based on 20 metrics, including fees. You can even see how your company's plan stacks up against those offered by similar companies.

If you have concerns about the fees charged by your plan, contact your HR department and ask about the possibility of having lower-cost funds added to your plan, or even switching to a lower-cost plan administrator.

8. Don't withdraw money early

A 401(k) is designed to help you save for retirement. Unfortunately, many participants treat them like piggy banks that can be raided when money is tight. But that leaves workers less prepared for retirement, and possibly on the hook for taxes and penalties. In fact, in 2011, the IRS collected $5.7 billion in penalties related to the early withdrawal of retirement plan funds. That means some $57 billion was withdrawn from such plans early. While we strongly discourage it, here's how you can tap your retirement funds early if absolutely necessary.

  • Loans
    To qualify for a loan, no demonstration of need is required. In many cases, the borrower does not need to disclose the purpose of the loan or demonstrate the ability to repay. The interest rate is set by the plan, usually one or two percentage points above the prime rate. With such favorable terms, it's no wonder that 21% of plan participants whose plans permit loans have a loan outstanding, according to EBRI.

    The maximum loan amount is the lesser of 50% of your vested balance or $50,000. Most loans must be repaid within five years. If a loan isn't repaid according to the terms of the plan, the money is considered a taxable withdrawal. If you are younger than 59½, a 10% IRS penalty will be assessed as well.

    One of the biggest cautions about taking a loan from your 401(k) is if you leave your employer — voluntarily or otherwise — you typically have to repay the loan in full within 60 days. That can be a back-breaker in the event of an unexpected job loss.

  • Hardship Withdrawals
    If you experience "an immediate and heavy financial need," you may be able to withdraw an amount necessary to meet that need, up to the amount you have contributed, and sometimes including your employer's contributions. Such needs could include certain medical expenses, payments necessary to avoid eviction or foreclosure, funeral expenses, and even money needed to purchase a principal residence or pay for school. Such withdrawals are taxable and subject to a 10% penalty, except in the case of disability or for certain medical expenses. The money cannot be repaid to the plan and you may not be allowed to make new contributions for six months.
     
  • Cashing Out
    If you leave your employer, you will have four choices regarding your 401(k) money. You could leave it in your former employer's plan, transfer it to a new employer's plan, roll it into an IRA, or take the money in cash. Many people, especially young people, make the mistake of taking the cash, subjecting themselves to taxes and a 10% penalty. According to Fidelity, about 40% of workers ages 20-39 cash out their 401(k) funds when they leave their job.

    In most cases, rolling the money into an IRA is the best choice because it gives you the greatest investment flexibility. Call or visit the website of Fidelity, Schwab, or the broker/mutual fund company of your choosing. They'll make it very easy for you to do a tax- and penalty-free roll-over.

Conclusion

Recent innovations in workplace retirement plans have focused on getting more workers to participate via automated enrollment, and then making the investing process as easy as possible via automated contributions, automated investment selection, and even automated asset allocation.

In some ways, the recent emphasis on ease of use means workplace plans have come full circle, from defined-benefit traditional pension plans that required little involvement on the part of participants, to defined-contribution plans that required much involvement, to defined-contribution plans that now require much less involvement.

But don't be lulled into complacency by today's easier, friendlier defined-contribution plans. They still differ from the defined-benefit plans of yesteryear in one quite significant way. The responsibility for the ultimate outcome — saving enough for retirement — rests squarely on your shoulders. The ideas discussed in this article should help you manage that outcome successfully.