Updated: Jul 13
Sorry to be the bearer of bad news, but your 401(k) provider is not acting in your best interest!
Instead, their fiduciary obligation is to the plan sponsor, i.e. your employer.
This means they can't manage your 401(k) nor offer personalized financial advice to you specifically. Their sole purpose is to provide you and your co-workers with a diversified list of funds and offer generalized guidance on which ones are considered risky, which are conservative, and how to pick a target-date fund.
Rest assured, none of this advice is tailored to help you individually.
It's your responsibility to help yourself and decide how much to save, where to save it, which funds to pick, when and how often to rebalance, etc.
This "DIY" approach is fine for the minority of investors harboring the knowledge and expertise to manage their own investments, or those working with a personal financial advisor who can assist them along the way.
Folks in need of assistance are left having to navigate through lengthy plan documents, complex summary plan descriptions and confusing fund listings to try and make sense of it all. This in-turn can lead costly financial problems in retirement.
If you're interested in making the most out of your company's retirement plan, here are 5 Ways to Optimize Your 401(k) in 2023:
Please note that as with all of my posts, this is for informational and entertainment purposes only and should not be considered investment, financial, tax or legal advice. Please consult your tax or financial professional before carrying out any of the strategies discussed below.
1. Get the Match and Move On
The biggest benefit to 401(k) plans is the company match. The reason being it represents a substantial guaranteed return on your investment depending of course on how much you contribute and the amount of the match.
401(k) benefits vary from plan to plan, though most companies offer to match either dollar for dollar what you put in up to a limit, or match a percentage of your contribution with a cap.
For example, a 50% match up to 6% (a common structure I've seen recently) means if you save 6% of your pay, your company will contribute another 3%. In other words, a 6% contribution gives you an instant 50% return on your money.
Understanding how the company match works is critical as saving above and beyond that amount may not be the best strategy for you.
In reality, there are better places to consider parking these additional savings each month than a 401(k). That's because most 401(k) plans have very limited investment options to choose from which can hinder your ability to personalize your investment strategy and ensure sufficient diversification.
On top of the lack of fund options is the pre-tax nature of a 401(k) plan. If your company's retirement plan doesn't offer a Roth option (more on this later), you'll likely end up with all of your retirement funds in a pre-tax asset that you'll eventually have to pay taxes on when you retire which may be higher than your tax rate today.
Lastly, you won't be able to touch this money until age 59 1/2 without getting penalized. This isn't necessarily a bad thing but may not be the optimal use of funds for small business owners needing access to capital, those with little to no emergency fund or others with personal financial goals requiring liquidity like investing in real estate or putting a down payment on a vacation home.
Unless you're in a high tax bracket today and have sufficient excess cash flow to max out your 401(k) and then some, it may be better to consider saving enough to get the company match, then looking at other savings options that fulfill a specific, more pressing financial goal.
2. Balance Paying Taxes Now vs Later in Retirement
According to a recent Fidelity survey, 80% of company retirement plans offer a Roth option. So if you're covered by a 401(k) plan at work, there's a good chance you'll be able to contribute to a Roth 401(k).
Unlike traditional 401(k) savings, Roth contributions aren't tax deductible and are instead made using after-tax dollars. The investments will grow tax-free like under a traditional plan, but when it comes time to take money out, the Roth 401(k) offers tax-free distributions. This can home in handy and aid in reducing your tax burden during retirement as other common sources of income from social security, pension, and required minimum distributions are all taxable.
In addition to tax-free withdrawals, Roth 401(k)s don't have required minimum distributions.
The IRS requires owners of traditional IRAs and 401(k)s to take a portion of their money out each year starting at age 73 (based on the Secure Act 2.0) regardless if they want to or not. A Roth 401(k) plan gives you the freedom and flexibility to withdraw your contributions whenever you want.
That's not to say you should ignore a traditional 401(k) plan altogether, or think you have to choose one or the other.
For example, if you're in a high tax bracket now, a traditional 401(k) plan might be more advantageous if you believe your tax rate may be lower in retirement. Those in the middle brackets may benefit from splitting their 401(k) contributions 50/50 between a traditional and Roth to get the best of both worlds.
It's important to remember there's really no right or wrong mix. The fact you're saving money is a good thing. Optimizing where those savings go and diversifying the types of tax-advantaged accounts is even better.
If you're unsure where to park your retirement savings or what mix is best, reach out to a professional for help.
3. Choose Your Funds Wisely
The average 401(k) plan has a little more than 20 different funds for participants to choose from. Often, this lineup will include a series of target-date funds, a set-it-and-forget-it strategy that aims to transition from an aggressive, all-stock strategy towards a more conservative one as you inch closer to the fund's "target retirement date."
In addition to target-date funds, your plan may also offer index-funds which merely track the performance of a specific index like the S&P 500.
Lastly, you may expect to see a handful of actively managed mutual funds that attempt to outperform their respective index on a risk-adjusted basis.
So, which funds do you choose?
Before making your fund selections, you'll want to first determine how you plan to manage your 401(k) moving forward.
If you don't want to pick funds and manually rebalance throughout the year, a target-date fund that matches the approximate year you plan to retire may be the way to go. You just have to be comfortable with your strategy becoming more conservative as you age regardless of your risk tolerance and other economic factors.
For those looking for more personalization of their investment strategy, consider selecting funds that match your risk tolerance and time horizon until retirement. More risk generally means more equity exposure which is typically correlated with length of time until retirement.
However, that doesn't necessarily mean younger participants should always be aggressive and older ones conservative. I've worked with clients in their 20s who prefer a healthy bond allocation and several in their 60s and 70s who are comfortable with an 80% weighting in equities.
In addition to risk tolerance and time horizon, you'll want to ensure your fund selection is diversified. That means not just owning the S&P 500 but looking to other areas of the equity market including mid-caps, small-caps, real estate, and international for example.
For fixed income, you'll want to consider the type of credit you're investing in, i.e. government, corporate, etc. as well as duration which measures a bond's interest rate risk (the higher the duration, the more movement in bond price as rates change).
Lastly, you'll want to be mindful of the fund's expense ratio and focus on keeping your costs as low as possible. Actively managed funds tend to charge the most in fees, followed by target-date funds with index-funds being the least expensive.
4. Establish a Plan for Rebalancing
Note: If you're a target-date investor, feel free to skip this section all together as target-date funds will rebalance for you.
Rebalancing is the process of adjusting your investments' allocation in order to remain in line with your initial objective. This is crucial since your portfolio's weightings in stocks and bonds may shift over time due to the natural ebbs and flows of the market.
Rebalancing helps to maintain a consistent alignment with your investment goals and risk tolerance. For example, a bear market may cause an 80/20 stock/bond portfolio to change to 72/28. By rebalancing, you're buying low (stocks) and selling high (bonds) in order to get back to the 80/20 mix.
Another benefit to rebalancing is that it instills discipline in your financial regimen. If you're staying on top of your 401(k) allocation, it's likely you'll be more engaged with other areas of your personal finances allowing you to remain on track with your goals.
If you've never rebalanced your 401(k) plan before, here is a brief guide to help you get started:
1. The first step in rebalancing your 401(k) plan is to establish your desired asset allocation. This is the percentage of your portfolio that you should allocate to various investment classes, including stocks, bonds, and cash. Your risk tolerance, investment objectives, and time horizon should be the foundation of your intended asset allocation.
2. Next, you'll want to set a schedule for rebalancing. At the very least, I'd recommend looking at your portfolio once or twice per year to determine if any changes are required.
3. With a schedule in place, you'll want to consider acceptable drifts for rebalancing. That is, how much will you let your allocations deviate from their targets. For example, if you decided on a 5% drift from your 80/20 target mix that's now 76/24, you wouldn't need to rebalance since the weightings only moved 4% from the objective.
4. If your portfolio has drifted outside your acceptable limit (say 6% based on the example above), you may need to sell certain investments and purchase others to move your portfolio back in line with your target allocation. Every 401(k) platform is different, but most that I've seen allow you to modify the percentage allocation for each fund within your online portal.
Rebalancing is a continuous process and requires ongoing monitoring in order to keep your portfolio's asset allocation at the desired level.
5. Take Advantage of the "Mega" Backdoor Roth
If you really want to accelerate your path towards retirement, have already maxed out your 401(k) contributions and exhausted other savings options, a Mega Backdoor Roth may be something for you to consider.
For plans that offer after-tax contributions and in-service distributions (not all do), a Mega Backdoor Roth 401(k) is a strategy that involves making additional, after-tax contributions above the annual limit (which in 2023 is $30,000 if you're over 50) and then converting those dollars to a Roth 401(k) account.
This is similar to a Backdoor Roth IRA except that the savings amounts are larger and done through your 401(k) provider.
A Mega Backdoor Roth 401(k) effectively allows you to expand your contribution limits and save more money in a qualified retirement account that won't be taxable in retirement.
How It Works
Let's assume Jane Smith is 51 and currently contributing $30,000 this year in her 401(k) plan. We'll also assume Jane's employer matches $7,500 for a total of $37,500 in employee and employer contributions.
For 2023, the IRS limit for total 401(k) contributions to a participant's (over age 50) account is $73,500. So if Jane wanted to save even more money on top of the $30,000 she's already socking away for retirement, she can elect to make after-tax contributions of up to $36,000 ($73,500 IRS limit - $37,500 total contributions) this year into an after-tax 401(k) account, then convert that money to a separate Roth 401(k) account. So all-in, Jane would be contributing $66,000 to her 401(k) in 2023.
Setting up a Mega Backdoor Roth can be complicated. As such, I'd recommend reaching out to someone in your HR department or your 401(k) representative directly to first determine whether or not your company offers this option within your plan.
If it is offered and you've decided to move forward, work with your plan rep, HR and 401(k) provider to ensure everything is setup correctly with payroll deductions, pre-tax contributions, after-tax contributions and conversions. There are a lot of moving parts here and you want to be certain it's handled correctly as even one small mistake can end up costing you money in penalties and taxes.
A fiduciary advisor is someone who works closely to help you achieve your personal financial goals while always acting in your best interest. Rest assured, this is not what you get with in a 401(k) plan.
Accordingly, it's your responsibility to act as your own fiduciary if you want to fully optimize your 401(k) benefits.
To make the most of what your plan has to offer, arm yourself with basic knowledge of the plan including the employer match, fund lineup, fees and options for after-tax and Roth contributions.
Next, make the appropriate tweaks to your contribution percentage, contribution type, asset allocation and fund selection so that your 401(k) strategy is closely aligned with your overarching financial plan.
When in doubt, seek out a licensed professional.