401k 101

When I was just starting my job, I didn’t earn a lot of money, plus I have to pay my wife’s tuition, and I may fail to get green card and have to go back to china in that case.

So I didn’t choose to contribute to 401k at the beginning. A lot of my coworkers couldn’t believe their ears when they hear I chose to not join 401k, to them, 401k is like tax shelter heaven.

One of the reasons I chose to pass-by is the fear of not able to withdraw the money when I need it (for education, buying house, layoff or simply going back to China). Later, I have learned that this fear is unfounded. First, if I get layoff, I can simply rollover 401k to IRA, and I can withdraw IRA money at any time as long as I pay the 10% penalty. Second, even though I can’t rollover 401k to IRA until I leave my company, in IT field, it is very common for people to change jobs, so my 401k money is easy to rollover to IRA because we simply change jobs quite often.

Still, 401k is not like what the fund managers would like you to believe. 401k is not good for everyone!

The first question is how soon you would expect to use the money. Ideally, we would like to save as much as we could for retirement or for whatever emergencies ahead. However, quite often people need a large lump sum to buy house or pay for education for themselves. If these events will likely happen very SOON, and you MUST withdraw 401k/IRA money to achieve that, 401k may be not for you. Of course, the hope is to use some other savings to do that, but the reality is you may not save enough to purchase a house as fast as you would like to. Assuming the housing market doesn’t have any bubble and house is not expensive, house is a good investment too, in that case, buying a house as early as possible is not a bad idea.

Assume a young couple really want to buy house within 4 years and the house is a good deal, and they can’t have enough money to buy house unless they use 401k money, then it is better for them to not enroll 401k at all. (Here, I assume you are a disciplined saver. For people who like to spend any extra dollar they get in pocket, 401k is a good way to force them to save for sure).

In all other scenarios, however, it is wise to enroll 401k. If they don’t need to buy house until 10 years later, or they don’t need to use the money until layoff, it is good to have money in 401k. In the layoff or early retirement case, the person would have lower tax brackets when they withdraw from IRA since the withdraw from IRA is much lower than normal yearly salary. So this lower tax brackets usually covers the 10% penalty. Considering the tax deferral over these years, it is still a gain for layoff case. In the case where the person doesn’t need the money until retirement, having money in 401k could end up in 100% or 200% more total balance (depending on your tax bracket) comparing to investing to non-retirement account with S&P 500 index fund, not mention that many people don’t invest into stock in non-retirement account.

If your employer offers some good match on your 401k, it is almost always better to maximize the 401k match, no matter if you need to use the money in short term (unless you really really have to use it before you leave the company).

After deciding whether to enroll in 401k, the next question is: what category to invest?

This is largely depend on two factors:
1. Do you likely need the money in short term?
2. Your loss tolerance.

If you have to use most of the money within next 5 years, you probably shouldn’t enroll in 401k at all. If you have to use most of the money within the next 10 years, you don’t want to put more than 50% into stock. If you don’t need most of the money until retirement (most people fall into this category), you should invest 80%-90% to stock fund unless you don’t have good tolerance to loss. Yes, most people don’t have good tolerance to paper loss, but in order to achieve good investment return, you have to have good tolerance to loss. You have to educate yourself and understand the basics of stock market and don’t panic when you have 50% paper loss. After all, in 20-30 years scale, investing on stocks almost certainly will give better returns than other alternatives. The long term capital gain is roughly determined by the sum of three ratios: GDP growth rate 3% + inflation rate 3% + dividend rate 2% = 8%. By buying to an index in long term, your gain is tied to the American business, nothing to do with the stock market.

However, if your loss tolerance is really bad and you just can’t help it, it is probably wise to have no more than 50% stock fund in 401k.

The third question is: what fund to pick.

As many *true* experts suggested, it is better to buy index fund with very low fees unless you really know the fund and the fund manager. 99% of the people don’t have enough skills to pick a good fund, given that 80% of the mutual fund can’t beat the index, it is better for regular folks just pick low fee index fund instead. These mutual funds couldn’t beat index because they have higher fees and because they actively manages the fund (not in a good way usually). I can bet that if normal folks truely know how the average mutual fund managers manage their portfolio and how the fee structures are determined, they won’t even want to touch the mutual fund again. Not many people are aware of these facts because news don’t want to let people know, after all, why offend some rich financial firms who had the money and power?

In 401k, the index fund could be vanguard SP500 index fund. In IRA, some low fee ETF 500 index fund could beat vanguard fund because they have even lower fees (because they are close-ended fund and has no redemption pressure and no redemption cost, in another word, they are even more passive in an already passive index fund). Some ETF fund’s fees goes to under 0.1%. Many people may not feel that 1% fee is a big deal, but consider this: the difference between bond and stock is only 3% return, so you risk your money to achieve 3% more returns per year in 20-30 years long term. Do you want someone who doesn’t do anything good to get 33% of that extra return from you? After all, 1% per year adds up can make a big difference after 30 years.

Once bought into the SP500 index fund, it is better to not time the market for normal people and never sell the fund until the "extreme". The "extreme" happens when the bubble gets too big (150% above fair value and everyone around you are extremely excited about stocks and never worry about losing money at all). If you can’t determine the bubble, you shouldn’t sell the fund at all until you need to use the money.

Since there is a chance for US dollar crush, it may be OK to move 10% – 20% from SP500 to international stock index fund, but international market is currently overvalued (I believe), so it is hard to say which is better.

The other 10-20% could be put to some safe bond fund like government bond fund. However, for right now, the bond rate is very low already, so a long term bond fund may not be as good as money market, since money market has the flexibility of getting higher interest rate later. The reason we need at least 10% on cash or very safe bond is to prevent some catastrophic events. 10% may not seem to be a lot right now, but imagine in some real catastrophic events, if stock market goes down by 80%, 10% becomes 33% of your portfolio at that time.

Last, for young people, even if they chose to not save in 401k, they still need to decide whether to enroll in roth IRA, or completely use non-retirement account. Almost always, it is better to enroll in roth IRA. Roth IRA’s principle can be withdrawn at any time without penalty (but interest on the principle is subject to tax and 10% penalty), and for most near term urgent needs, principle is enough (since the interest is small anyways in near term), so the penalty and tax should almost never incur. However, Roth IRA limit is $5000 per year, so you may still have to put some money to non-retirement account if you have more than $5000 to save. If your employer offers roth 401k, and you have more than $5000 to save, and you need to use the money within 5 years, and you assume you will leave your current employer before you need the money, you can consider roth 401k too. (Anyone wants to add to this list?)


Some last piece of advice, never rollover a 401k to another 401k, and never rollover an IRA to 401k. When you leave your company, always rollover the 401k to an IRA.
First, 401k has more restrictions on withdraw, but IRA can be withdrawn at any time as long as you pay the penalty.
Second, 401k usually has more fees (in many small companies’ 401k plans, the same fund would charge 0.5% – 1% more fees than IRA account).
Third, 401k can only select a limited selection of funds. Some funds have pretty bad management and they will destroy the performance rather than help it. In IRA, you can buy almost anything, from thousands of mutual fund, to individual stocks, bonds and preferred stocks.

Plus, you can always rollover from IRA to 401k if you really want to later, but you can’t rollover 401k to IRA unless you leave the company. I am sure this comparison is something the 401k fund manager doesn’t tell you.