What Should I Do With My 401(k)?
What should I do with my 401(k)?
It’s one of the most common questions we hear. The 401(k) - or another flavor of employer-sponsored retirement plans - makes up a huge piece of total retirement savings for so many investors, and the difference between investing it well and investing it poorly could dramatically change someone’s retirement scenario.
[Note: if you prefer video, scroll to the bottom of the page to watch.]
Consider a 40-year old worker who has $500,000 in their plan. They want to retire at 60 years old. Here are three scenarios. All details are the same, except for the assumed rate of return:
When looking at a 401(k) balance, it may help to remember the money isn’t all yours. Withdrawals are taxed as ordinary income, so you and your 401(k) have a silent partner in the account: the federal government. That’s why we included the final two rows, to include estimated taxes and an after-tax value. Why 24% for taxes? No particular reason. If your marginal rate is higher or lower, just keep in mind how that impacts the after-tax values.
Based on these assumptions, the after-tax difference between earning 4% and 7% is nearly $1 million. Obviously, this can have a big impact on retirement details.
So, back to the original question, how should someone invest their 401(k)?
An increasingly common answer is in something called a target-date fund, or TDF. If you aren’t sure which fund is a target-date, the name is usually a dead giveaway. They typically include a year (like 2030, 2040, etc.) in the fund name.
There are plenty of reasons to like TDFs. For many investors, TDFs remove the urge to make changes to their investments inside the 401(k) or other retirement plan. Since the TDFs automatically rebalance and invest more conservatively over time, it’s often considered a set-it and forget-it approach for retirement savings.
But what if you aren’t like everyone else retiring in 2040? Let’s use that retirement date (2040) and look closer at the options.
2040 retirement: A short case study
There are 51 unique funds in Morningstar’s 2040 target date category. Those 51 funds have about $214 billion in investor assets. 90% of those assets sit in the eight biggest funds, managed by these firms:
Vanguard
American Funds
Fidelity
T. Rowe Price
Blackrock
TIAA-CREF
Principal
JPMorgan
These firms probably sound familiar – they’re among the largest asset managers in the world. And the fund names sure do sound appealing, too, including things like, “SmartRetirement” and “Freedom.” Who doesn’t want to be smart and free! I’m still waiting for the “Dumb Captive” retirement fund.
Jokes aside, how much should someone retiring in 17 years have invested in stocks? T. Rowe Price thinks the answer is 86%. Vanguard says 73%. That’s a pretty big range. Managers of the other top eight 2040 funds are somewhere in between. If we zoom out further to include all funds in the 2040 category, the vast majority invest between 60% and 90% to stocks. That’s a HUGE difference!
Take a look at cash. Cash is often the worst enemy of long-term investors, as cash typically loses real value to inflation. Yet, the four biggest 2040 funds have at least 4.5% in cash!
Source: Divvi Wealth Management, Morningstar Direct
does your retirement year define you?
So, are TDFs bad? Not at all, and they are probably a great solution for many workers saving for retirement. Morningstar’s Mind the Gap report estimates investors in allocation funds (like TDFs) are among the most successful, at least in terms of minimizing the difference between an investor’s return and the return delivered by the fund itself.
However, for those who don’t like a one-size-fits-most approach to retirement, there may be other good options. Perhaps there is more to your story than, “I plan to retire in 2040.”
For example, do any of these situations sound familiar?
You have significant assets outside your 401(k) or company retirement plan
You are a high earner, potentially paying very high tax rates on ordinary income and much lower rates on dividends and long-term capital gains
You are much more (or less) willing to accept risk than the “average” 2040 retiree
You are much more (or less) able to accept risk than the “average” 2040 retiree
If so, the TDF might not be the best solution. Thoughtful planning may suggest a portfolio that looks quite different than the “average” 2040 retiree.
Customizing the 401(k) allocation could mean a more tailored approach to risk, reaching personal retirement goals, and tax planning, all of which are unique to you.
You can email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversation.
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