In 1980, corporate benefits consultant Ted Benna was helping a company change its employee bonus plan into a deferred profit-sharing plan. Knowing the change might not be popular with employees, he scoured the tax code in search of ideas. He found an obscure provision in Section 401(k) that allowed workers to set aside a portion of
their salary on a pre-tax basis. That alone couldn’t compete with a cash bonus, so he came up with an incentive: a company match.

Today, the 401(k) plan is the most prevalent workplace retirement program — along with its close cousins, 403(b) and 457 plans — with 68% of full-time workers having access to such plans.

As common as they have become, 401(k) plans have an image problem. They come under regular media criticism for their fees, complexity, and perhaps most of all, their inability to deliver guaranteed retirement income. Many people, it seems, long for the “good old days” when employers provided retirees with a gold watch and a reliable stream of pension income.

The problem, according to Nevin Adams of the American Retirement Association, is that “those ‘good old days’ never really existed, nor were they as good as we remember.” Indeed, the Employee Benefit Research Institute found that as far back as 1975, less than 25% of people age 65 years old or older had pension income. Even among those who worked for an employer that offered a pension, most in the private sector didn’t stay long enough with a single employer to accumulate the service levels needed for a full pension.

As 401(k) “founder” Ted Benna recalled, “In my first job, I was covered by a pension plan where you had to be 30 if you were male to even become a participant, 35 if you were female, and you had to stay until you were age 60 to get any benefit. That was the good old days.”

Today, the defined-contribution 401(k) plan is the most widespread type of workplace retirement plan, largely replacing the defined-benefit traditional pension. Employers prefer defined-contribution plans because they are less costly and they shift the investment risk to employees. (When this article refers to a 401(k) or “workplace plan,” those terms are meant to include 403(b) and 457 plans as well, which are available to many employees of tax-exempt organizations, such as schools, charities, and government agencies.)

While defined-contribution workplace plans do require more knowledge and active involvement by participants than traditional pensions, they provide 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 how to make the most of your workplace plan.

1. Participate

To benefit from your workplace plan, you must participate! That may seem obvious, yet many people who could participate do not. According to Fidelity, the largest administrator of 401(k) plans, about 27% 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. However, 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 situations when even we recommend taking a pass, at least temporarily. Ideally, it’s best to be out of debt (with the possible exception of a reasonable mortgage) and to have emergency savings totaling three-to-six months’ worth of essential living expenses before signing up for your workplace plan.

However, that’s a high bar for some. For those who can put money toward getting out of debt and building an emergency fund each month while also investing at least some through your workplace plan to get the full — or even a partial — match, that would be a good balance (more below).

At a growing number of workplaces, you don’t even have to choose to sign up. To get more people saving for their later years, many companies now make participation automatic, though not mandatory. If you don’t want to participate, you have to opt out, rather than opt in. Today, 54% of Vanguard-managed plans use auto-enrollment.

Such programs have proven effective in getting more workers to participate. At Vanguard, the participation rate in auto-enrollment plans is 92%. In plans that don’t use auto-enrollment, that drops to 61%. (There are also some downsides to auto-enrollment, which we’ll discuss below.)

2. Get the match

If you are eligible for an employer match, try to contribute at least as much as is needed to get the full match. In a typical arrangement, your employer may match your contributions 50 cents on the dollar up to a maximum of 6% of your salary.

Suppose you make $60,000 per year. To contribute in a way that earns the maximum match, you would contribute $3,600 per year (6% of your salary). In return, your company will kick in $1,800 (50 cents for every dollar you contributed). That’s the easiest money you’ll ever make — a guaranteed 50% return on your money!

Let’s look more closely at just how powerful this benefit is. Sticking with our example of a $60,000 salary and a 6% contribution rate, beginning at age 30, if you earn an average annual return of 7% on that money, and if your salary increases 3% per year, your balance will be almost $1.1 million 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 about $550,000 more!

3. Determine how much you need to save

As of April 2020, the average 401(k) balance among participants with a Vanguard plan was $101,771. However, averages can be deceiving — a small number of participants with large balances can skew the average upward. The median (the midpoint of all accounts) balance in a 401(k) account was only $25,570, according to Vanguard.

The primary controllable factor that determines how much money you’ll accumulate in a 401(k) plan is how much you contribute. (Other factors, which we’ll discuss later, include what you choose to invest in and whether you borrow against your balance.) In 2021, 401(k) participants are allowed to contribute up to the federal cap of $19,500, and another $6,500 for those 50 and older. However, few people are contributing that much. In Fidelity-managed 401(k) plans, participants contributed an average of $7,330 in 2020.

Here’s one instance where automation can be unhelpful. For many years, the typical automated default contribution rate was just 3% of an employee’s salary. While that has been edging up, with 55% of companies now using 4% as the default, that’s still too low for most people to accumulate enough money for retirement. A 2019 Schwab study found that 33% of employees who were auto-enrolled in their company’s retirement plan never changed their contribution rate.

Many companies have added an escalation feature, which automatically increases employee contribution rates by one percentage point per year up to a maximum of 15%. However, employees typically stay with one company for less than seven years, which means many employees at companies that use auto-enrollment and even auto-escalation are unlikely to be saving enough for their later years.

Our advice? Take the time to estimate how much you’ll need for retirement and how much you need to save each month to get there. You could use the comprehensive MoneyGuide financial planning software that’s available to SMI Premium-level members for a one-time $50 fee. Or, at the very least, run some numbers using one of the free online calculators that are readily available.

4. Make an informed tax choice

About 75% of 401(k) plans now offer both a “traditional” 401(k) plan and a Roth option, according to a survey by the Plan Sponsor Council of America. With a traditional 401(k), your contributions are made pre-tax. That means every dollar you contribute 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 to $70,000. But the tax bill isn’t torn up; it’s deferred. When you take money out of the plan in retirement, you’ll owe 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 break 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, however, even if made to a Roth plan.)

Deciding between a traditional or a Roth 401(k) 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 probably 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). 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.

For higher-income earners, a 401(k) plan may offer an opportunity to participate in a Roth plan that you would otherwise be excluded from. With a Roth IRA, there are income-based eligibility restrictions. With a Roth 401(k), there are no such restrictions. One other way Roth 401(k) plans differ from Roth IRAs is that a Roth 401(k) requires participants to take minimum distributions beginning at age 72, whereas there is no such requirement with a Roth IRA. To avoid that requirement, roll over your Roth 401(k) balance to a Roth IRA.

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, we encourage you to contribute enough to take full advantage of the match. Then open an IRA where your investment options, and therefore your ability to use the SMI strategy of your choice, will be wide open.

Just keep in mind that you will be faced with the same traditional vs. Roth decision you may have dealt with in your 401(k), you’ll be limited in the amount you can contribute to the IRA (currently $6,000 per year, and another $1,000 if you are 50 or older), and you may be restricted by your income.

SMI’s recommendation for funding priorities is as follows. First, take full advantage of any match at your workplace plan. Then, if eligible, 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. Although skipping the IRAs and keeping all your money in the 401(k) may simplify your retirement savings a bit, unless you have a “brokerage window” in your company plan (see below), an IRA is likely to give you much more flexibility to invest exactly as you want to.

What if your workplace plan doesn’t offer a match? In that case, fully fund an IRA first and then contribute to your company plan if you need to invest more.

6. Choose the right investments

The number of investment choices available within 401(k) plans has been in steady decline. Today, the average 401(k) plan has only 15 investment choices, down from 26 in 2010, according to Fidelity. Fortunately, a growing number of plans offer a brokerage window, which opens up many more investment choices. A brokerage window gives you access to the hundreds of investment options offered by a broker such as Fidelity, Vanguard, or Schwab — although brokerage windows typically don’t allow investments in exchange-traded funds (ETFs). Here’s how you could use one or more of SMI’s strategies to manage the investments in your workplace plan.

  • Just-the-Basics
    This is the easiest SMI strategy to implement within a 401(k) plan. It is designed optimally to be used with Vanguard index funds, but it is fine to substitute similar funds from Fidelity, Schwab, or another fund family. Typically, such funds are readily available within a 401(k) plan (and certainly through a brokerage window).
     
  • Fund Upgrading
    In most plans, access to a brokerage window is essential if you are to utilize this strategy. However, if you don’t have access to a brokerage window, all is not lost. The SMI Personal Portfolio Tracker enables plan participants without broker-window access to use a simplified version of Upgrading that has produced great returns for many retirement savers over the years.
     
  • Dynamic Asset Allocation
    DAA is best implemented through a brokerage window, ideally one that allows use of ETFs (which, unfortunately, most don’t allow). Still, DAA can be at least partially implemented within more restrictive plans (at this link, see Step 3). Most plans offer good mutual fund options for U.S. Stocks, Foreign Stocks, and Bonds, as well as a money-market or cash option. That leaves DAA options Real Estate and Gold as the wild cards that your plan may or may not include. If not, if you have an IRA, you could view your 401(k) and IRA as parts of a single portfolio, implementing DAA across the accounts and using the IRA to invest in the funds you don’t have access to in your 401(k).
     
  • Sector Rotation
    To implement this optional add-on strategy, you’ll need access to a brokerage window, ideally one that allows you to invest in ETFs.

An increasingly popular investment option in workplace plans is the target-date fund (TDF). In fact, TDFs have become the default choice in many such plans. These funds offer compelling benefits, but they also come with some necessary cautions.

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 2050 Fund. TDFs provide a pre-set asset allocation that the fund company believes is appropriate for the targeted retirement date, and which the fund company changes automatically over time. For example, a 2050 fund, with its relatively long time horizon, would be heavily invested in stocks right now, but would become more conservative over time, increasing its bond allocation while reducing its stock allocation.

But all target-date funds are not created equal. One fund company’s asset allocation for its 2050 fund may be quite different from another company’s offering with the same target date — which can lead to quite different results. So, if you’re intent on using a TDF, be sure to determine your optimal asset allocation5 and choose a fund with that allocation, even if its target date is different than your intended retirement date.

7. Cautiously consider guaranteed income options

Following passage of the SECURE Act in 2019, annuities are now expected to become increasingly common options within 401(k) plans. While plans have long been permitted to offer annuities, many administrators were hesitant because of liability concerns related to the possibility that the insurer could go out of business and be unable to make good on its obligations. The SECURE Act lowered that risk for employers (as long as they follow certain rules in selecting providers).

Annuities may look appealing to anyone who hungers for guaranteed retirement income. Our advice? Be sure to understand the pros and cons of annuities. If you decide that an annuity is right for you, keep in mind that you can choose a provider other than the one offered within your 401(k) plan. It’s wise to shop around. Check the offerings of low-fee providers, such as TIAA, as well as a comparison-shopping website, such as immediateannuities.com or blueprintincome.com (there are some newer players in this space as well).

8. Understand your plan’s fees

There are two main types of fees within 401(k) plans: those charged by the funds available to plan participants and those related to the expense of running the plan.

The most common mutual fund fee is a fund’s “expense ratio,” which covers its operating expenses. For example, a fund with an expense ratio of 0.5%, pays one-half of one percent of its assets in expenses. 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, but 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 to pay this fee, so unless the load is waived, avoid using load funds.

As for administrative fees, research shows that they are increasingly being shifted to employees. Workplace plans are now required to make fees more transparent via disclosure forms, so take a look at how much your plan charges. You also might want to assess your plan’s fees with the help of Brightscope, a free service that rates plans on various metrics, including fees. If you work for a relatively large employer, you should be able to 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 encourage the company to consider a lower-cost plan administrator.

9. Don’t withdraw money early

A 401(k) plan is designed to help you save for retirement. Unfortunately, many participants treat them like piggy banks that can be raided when money is tight. That leaves workers less prepared for retirement — and possibly on the hook for taxes and penalties. If you withdraw money prior to age 59½, you’ll be subject to income taxes (with a Roth, only your earnings are subject to taxes) and a 10% IRS penalty.

While we strongly discourage it, here’s how you could tap your retirement funds early if unavoidable.

  • Loans
    To qualify for a loan, no demonstration of need is required, nor do you need to disclose the purpose of the loan. 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 18% of plan participants whose plans permit loans had a loan outstanding at the end of 2020, according to Fidelity. 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 as income taxes.

    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 by the tax-return filing due date for that tax year.
     
  • 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, and the money is not allowed to be repaid to the plan.

    If you have a choice between taking a loan and a hardship withdrawal, take the loan since you will avoid the taxes and penalties if it is repaid.

Here’s one final caution about tapping your 401(k) money before retirement. If you leave your employer, you will have four choices regarding your retirement savings. You can leave the money in your former employer’s plan, transfer it to a new employer’s plan, roll it into an IRA, or take it in cash. Many people, especially young people, make the mistake of taking the cash, subjecting themselves to taxes and a 10% penalty. 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 the broker where you’d like to transfer the money. They’ll make it 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, this emphasis on ease-of-use means workplace plans have almost 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, and in recent years to defined-contribution plans that now require much less involvement.

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