Last week, we introduced 401(k) retirement plans and focused on their main two benefits:

  1. Tax Benefits
  2. Employer Match

This week we’ll close out the discussion with a little talk on Roth 401(k)s and some tips for choosing Funds inside your 401(k).

Roth 401(k)

On January 1, 2006 Roth 401(k) accounts were made available as a retirement plan option. Not all employers are offering them yet, but Roth 401(k) accounts should soon become as ubiquitous as regular 401(k) accounts are now.

The main difference between a Roth 401(k) and a regular 401(k) is that the Roth option uses after-tax dollars (much like a Roth IRA) for contributions.

The ability to use pre-tax dollars is one of the main advantages to using a 401(k); so why would you want to contribute to a Roth 401(k)? Well, the pay off is that when you (finally) withdraw money from the account you will have to pay ABSOLUTELY NO TAX. With a regular 401(k) account, you must pay full income tax on any withdrawal.

The way this ads up is that you will pay more taxes now and fewer taxes when you retire. For this reason, the general rule of thumb is that you should use a Roth 401(k) if you are expecting to pay higher taxes when you retire (because you’ll be making more) than you are now. Another sometimes overlooked question when making the decision is “Is $1000 a year now more important to you than $4000-$5000 a year will be to you when you retire.” We’re often trying to maximize our total wealth, but we still buy toilet paper even though toilet paper savings could add $13,000 or more to our retirement nest egg.

More information on Roth 401(k) can be found at SmartMoney.com and there is a pretty good Roth 401(k) Tool here that will show you side by side the difference between investing in a Roth or Regular 401(k).

Choosing Funds

0. Choose your distribution.
There is a lot of advice out there about this. Opinions differ. So search around and see what tickles you. In general, if you aren’t thinking of retiring too soon (within 20 years), you can afford to invest in all stocks. However, if you are bearish about the market or closer to retirement, you’ll want to mix in some bonds action. You might be able to deal with a 50/50 split with 10 years of the working life left, but would want to be closer to 90% fixed income investments vs. 10% growth investments by the time you retire.

Many plans will also offer funds that focus on international stocks. There is a lot of growth outside the United States. I plan on having at least 25% of my plan invested in international stock funds until I move to a fixed income distribution.

If you are completely clueless on how to distribute your funds, you might be interested in the “Balanced” funds offered by your plan. These funds are organized by the expected retirement date of their investors. For instance, the Fidelity Freedom 2020 Fund would be balanced for investors expecting to retire sometime between 2020 and 2029.

1. Check past performance.
Past performance does not guarantee future performance, but it’s not a bad place to start. Obviously, you’ll want to focus on funds that are performing better than others, but there are some other things to look out for. Be sure to check how the fund performed during a bad year. How did the fund do in 2001 or 2002? You want funds that will make you money during a bull market and also save your money during a bear market. Another thing to look out for is a good fund that just had a bad year. These guys are going to be fighting extra hard this year; just make sure the bad year wasn’t do to a manager change (see #2 below).

Be wary of jumping on the band wagon of “hot funds”. Often, if a fund has a good year, a bunch of new money will roll in. There is no reason to think that the fund will be as good at running 50 billion dollars as it was at running 5 billion. In a past article, Chris discussed the challenges big funds face.

2. Check the manager.
Mutual funds have a hard time holding onto their good managers. The reason for this is simple. Say I was a manager good enough to ensure 15% returns every year running funds as large as $10 billion. There are going to be a lot of wealthy people wanting me to quit my day job and concentrate on managing just their money. It’s hard to find a reason why a good fund manager wouldn’t move into the hedge fund business where they can charge higher fees to run less money (read: more money for less work).

Manager turnover is another reason why that fund that did 20% last year might not do so again. If you’re lucky, you might find a fund with good performance who’s had the same manager over the past 5 years. Don’t shy away from “star” managers like William Danoff, who has run the Fidelity Contrafund since 1990 (a fund I invest in).

3. Check the prospectus.
Somewhere inside the interface your employer provides you to manage your 401(k), there should be a way to access a more detailed view of each fund. The application my employer uses (a Hewitt product) shows Morningstar analysis for each fund. This analysis shows the funds’ distribution in cap-size, sector, and even the funds’ top ten holdings. Other key numbers to look out for are the expense ratio (what the fund charges) and the “total funds assets” (a bigger number here indicates a less flexible fund).

The Morningstar analysis offers excerpts from the fund’s prospectus which can be very useful. One interesting read is the “fund strategy”. Novice investors may glaze over reading this, but more experienced investors will be able to find funds with a philosophy similar to their own.

If you are having trouble getting this information through the application offered by your employer, check out Morningstar.com or go directly to the fund’s website to find the original prospectus.

Author’s gravatar

My rule of thumb for fund managers is to look for funds with managers who have been there for 5 years or more, and who are not near retirement. I find that many sites don’t talk about managers who are getting older. If a manager with solid creditials and a great track record is pushing his mid-60’s, it’s best to give that fund a third look (all prospects deserve two looks) before buying it.

Comments are closed.