A Common Mistake with Retirement Planning
By Charles Hopkins
Published 04/21/2006 | Finance
Most articles about 401(k) plans, traditional IRAs and Roth IRAs focus on rules and regulations. Contribution limitations and income tax issues usually take precedent.
Unfortunately, little attention is given to the matter of control. This refers to one's ability to personally manage the asset on an active and ongoing basis.
For example, when you join a 401(k) plan you are restricted as to the investment choices. Your plan sponsor makes that decision as part of their fiduciary responsibility.
In the past, this was a big concern because plan participants (i.e. the employees who enroll in their company's 401(k) plan) were often given terrible choices.
Sometimes, this was the result of ignorance on the part of the plan sponsor. However, with some publicly held companies it was the desire to encourage employees to invest in the stock of their own company.
Today, federal regulation mandates better investment choices. This means a plan participant is able to choose from a greater variety of investment styles, as well as a cash account that typically replicates a money market fund.
But, this is still insufficient. The ability to design the most appropriate investment plan continues to be severely limited in 401(k) plans when compared to the freedom of choice in IRAs.
It is important to review briefly what has happened over the last 20 years with retirement plans.
Not long ago, it was common for a company to provide employees with a defined benefit plan. This type of plan design guaranteed a stream of income based on length of service and average wages. The income began at what was then considered the normal retirement age of 65.
For many workers, the defined benefit plan, together with social security, ensured a sense of security for their future lifestyle. Obviously, times have changed considerably.
Today very few companies will assume the defined benefit plan liability. In fact, companies have shifted the responsibility for retirement savings to the employee by adopting 401(k) plans.
Some companies will match a portion of the employee's 401(k) contribution up to a maximum amount or percentage. But this doesn't come close to replenishing the void caused by the terminated defined benefit provision.
What is more, the investment opportunities in typical 401(k) plans are expensive due to excessive management fees and brokerage commissions. Even the so-called no load separate accounts have administrative costs that significantly reduce the net return for the average investor.
Most plan participants are oblivious to the costs associated with the administration of their plan. Also, they do not pay enough attention to the allocation of their investment.
A self-directed IRA hosted by a low cost online brokerage firm provides an opportunity to reduce substantially the ongoing costs related to retirement planning.
In addition, the IRA owner can invest in a wide variety of individual stocks, bonds and commodities to create a highly diversified portfolio. The 401(k) participant must take the total package of a bundled investment to include issues that can jeopardize the total return.
This is not to say 401(k) participation should be avoided. Not at all. But it should be coordinated closely with a IRA to enhance the overall strategy for long-term growth.
It's apparent that Congress must continue to provide expanded retirement planning opportunities for the individual employee. The rules will constantly change, but the writing is very much on the wall.
Companies will no longer provide guaranteed future benefits. Factors which contribute to this include the pressure of worldwide competition, the deterioration of union power, the ever increasing cost of health insurance and the peripatetic nature of the workforce.
Therefore, the individual employee needs to understand how to create a balance between the restrictions found in the 401(k) plan and the significant freedom of choice of the IRA.
Both instruments permit the postponement of income tax. Whether the investment principal is pre-tax 401(k) or tax deductible IRA is irrelevant. At some point the tax piper must be paid.
The strength of both systems is in the tax deferment because, in most instances, this will be a long period of time. In fact, many people choose not to withdraw any money at all from retirement accounts until they are forced to by federal regulation.
As stated earlier, rules change frequently. Therefore, it is important to know what restrictions are in place before making any investment choice. But the basic premise doesn't change.
Analyze both the 401(k) plan together with your ability to open a IRA. If your employer offers a matching provision, commit a portion of your pretax dollars to guarantee no less than the matching amount.
Anything over and above this figure should be allocated to a self-directed low cost brokerage IRA. This gives you the opportunity to enhance your total retirement investment.
If your income exceeds the limitation for deducting the cost of your IRA, do not let this to be the sole reason not to open the IRA. Your freedom of choice and long-term tax deferment can far outweigh your lack of deductibility.
In the final analysis, most people make financial decisions based on their level of comfort. Indeed, this frequently leads to less than desirable results.