Three Ways to Maximize Your 401(k) Contributions

Feb 11, 2022

Last week I shared advice from Ted Benna — the “father of the 401(k)” — on how to avoid some of the biggest mistakes many retirement investors make.

Benna’s guidance is an important start for anyone hoping to achieve their retirement goals. But it doesn’t address all the limitations of many 401(k) plans.

So today, I’d like to share a few more ideas that you can consider to further reduce your risk and maximize your returns in your retirement accounts.

We’ll start with my favorite: Choose a self-directed brokerage account from your 401(k) administrator.

This type of plan is exactly what it sounds like. It will allow you to invest your 401(k) in a wide range of traditional assets — including stocks, bonds, ETFs, mutual funds, even options, in some cases — just like a regular brokerage account.

It will give you much more flexibility in your investment choices, allow you to avoid the high-fee funds common in so many plans, and, in some cases, even save you from paying fees or commissions altogether.

Even better, if you’re a TradeSmith subscriber, it will also allow you to take full advantage of our tools to manage risk and build a well-diversified portfolio.

If your employer offers this option, I urge you to learn more. I invest for my own retirement in this type of 401(k), and it’s a fantastic alternative to a traditional plan.

Unfortunately, this option isn’t currently available at many companies. If that’s the case for you, it couldn’t hurt to ask your administrator to make this type of plan available. But chances are you’ll need to take another approach.

If a brokerage option is not available but your plan does offer at least a couple low-cost funds, you might consider a “hybrid” approach, using both your 401(k) and an individual retirement account (IRA).

In this case, you would invest only as much as necessary to receive your full company match in your 401(k).

Depending on your plan’s investment choices, you would invest in a low-cost target-date fund or one or more low-cost index funds like we discussed last week.

While there aren’t any official definitions of “low cost” that I’m aware of, I would generally define it as an expense ratio of 0.50% or less. (Some of the best target-date and index funds charge 0.15% or less today.) And I’d generally consider an expense ratio of 1% or more to be “high cost.”

If your plan has sufficient low-cost options, the All-Seasons portfolio I shared with Money Talks readers last year would be a great choice too.

You would then contribute any additional savings to the IRA, which generally will offer similar investment choices as a 401(k) brokerage account.

Only if you intend to exceed the annual IRA contribution limits — which currently are $6,000, or $7,000 for those age 50 or older — would you then contribute more to your 401(k).

This hybrid approach will help minimize your exposure to less-than-ideal funds while still allowing you to benefit from the essentially free money your company offers.

In my experience, most folks should be able to take advantage of some version of this approach.

However, there are some plans out there that offer neither a brokerage option nor any reasonably low-cost funds. And in this case, the decision is more difficult.

If your employer offers a relatively large percentage match, the hybrid approach may still make sense, even with relatively poor or expensive investment choices.

On the other hand, if the match is relatively small — or the plan’s investment choices are especially poor — it may not make sense. You may be better off forgoing new contributions to your 401(k) entirely and investing solely in an IRA, especially if you don’t plan to invest more than the annual IRA contribution limit.

There is one additional option here for folks who are closer to retirement age. It involves what’s known as an “in-service rollover.”

In short, you typically can only “roll over” or transfer a 401(k) to another retirement account — like an IRA or a new 401(k) — when changing jobs or retiring. Attempting to do so otherwise will create a taxable event and may even trigger penalties.

However, most plans will allow employees aged 59 1/2 or older to roll over some or all of a 401(k) to an IRA while still working.

Better yet, they’ll often allow these folks to repeat this rollover once per year, as well as continue to contribute to the 401(k) and receive the company’s match as they do.

In other words, if you’re eligible, this type of rollover can allow you to take advantage of your company’s match while avoiding most of the negatives of high-cost plans. You will have to pay fees for each year’s contributions, but you’ll then be able to transfer those funds tax-free to your IRA, where you can invest them as you choose.

Again, not every plan offers in-service rollovers. And the rules and conditions can vary by administrator. But if you’re 59 1/2 or older and invested in a less-than-ideal 401(k) plan, this could be a great solution.

Now, there is still one common question related to 401(k)s that I haven’t addressed. That is whether it makes more sense to contribute to a traditional 401(k) or Roth 401(k).

This is a contentious issue, and in most cases, there isn’t a clear right or wrong answer. However, several readers have asked for some guidance. So next week, I’ll wrap up this series with some general suggestions to keep in mind. ADD

In the meantime, if you have any questions on what we’ve covered so far — or would like to share your own experience on these issues — I would love to hear from you. As always, you can reach me directly at [email protected]. Please note that I can’t respond to every email, but I read them all.