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How To Manage Your 401K Wisely

OK, so maybe Hallmark doesn't sell cards celebrating 401k Day, but it is a nationally recognized day, and employers all over the country will be running seminars and other special events to teach people more about saving for retirement.

401k Day always falls on the first workday after Labor Day; so since this is The Early Show financial advisor Ray Martin's area of expertise, he shares answers to the most common questions and points out the biggest mistakes he sees people making.

One question that everyone asks him is: "Am I invested in the right funds?"

Most 401k plans offer 14 to 18 funds in which you can invest your retirement savings. The funds cover all of the major asset categories - cash, stock and bonds. It's safe to assume that your employer has generally tried to find funds that are well-managed and low cost. So how do you know which to choose?

Of course, this is going to take some research. You need to review each fund's performance history, fact sheet, description and prospectus. Ultimately, you need to compare the funds that are being offered in each category (cash, bonds, large company stock, small company stock and international stock) and choose the one that has the best performance and lowest costs.

If that work scares you a little, if you still don't feel confident in comparing the different funds, here's the good news: The allocation of your 401k money is more important than choosing the "right" funds.

"According to well-established industry research," Martin says, "over 90 percent of the risk and return of your investments in your 401k plan are the result of how you allocate your account among cash, bonds and stock funds. That means that less than 10 percent of your account's future performance will be the result of fund selection and market timing. Your investment allocation strategy is the most important thing to get right - once you create your strategy (what percentage of savings to allocate to cash, bonds and stocks) then simply fill in the proportions with the funds available in your plan."

Of course, this appropriate allocation is going to differ from person to person. The most general rule of thumb says that the younger you are, the more money you should have invested in stocks.

Stocks are more volatile than other investments but they also have the potential to earn the most money. If you have many years before you're going to need that retirement money, you can handle some ups and downs in your account. As you get older, you want to convert more of these investments to bonds, which are a safer, more stable investment. Of course the correct allocation also varies depending on your financial goals - do you hope to retire early? Borrow against your 401K to pay for child's college?

Here are three different sample allocations to illustrate this point.

  1. Single, 25 years old = Stocks 90 percent, Bonds 10 percent
  2. Married couple, mid 30s, one child = Stocks 75 percent, Bonds 15 percent, Cash 10 percent
  3. Married couple, mid 50s, hope to retire at 60 = Stocks 50 percent, Bonds 35 percent, Cash 15 percent

According to Martin, starting to save in your 401k plan as early as possible is also more important than choosing the "right" funds. You simply can't over-estimate the importance of this! He has an example that clearly illustrates this point.

Jane and John are the same age, have the same income, and same 401K plan. Jane immediately begins saving $100 a month. John waits five years, then, begins saving $100 a month. This means by the time that John begins saving, Jane has already tucked away $6,000. That doesn't sound terrible significant, does it? But get this: in 30 years, Jane will have almost $150,000 in her 401k, and John will have only $95,000. That five-year jump start gave Jane over $55,000 more in her 401k, compared to John.

As for the the biggest mistakes he sees people making with their 401ks. As discussed above - investing in a mix of funds that's not appropriate for an employee's age or financial goals - is the first mistake. The second big mistake Martin finds is that people simply don't contribute enough to their 401ks.

At the very minimum, you need to invest up to your company match. If your company agrees to match the first six percent of your annual contribution, then you need to contribute at least six percent. If you don't, you are literally leaving free money on the table. If you don't know what your company's match point is, find out. Ideally, he said, you should contribute 10 percent of your income to retirement.

If you want to contribute only 6 percent to your 401k and then 4 percent to another retirement fund such as an IRA, that's OK, too. However, Martin finds that people who contribute the whole amount to their 401k have better savings success because the money comes directly out of their paychecks; it never hits their checking account. It takes more self-control to have money in your hands and then pass it off to an IRA or other investment.

The final mistake that Martin sees investors make is that when their 401ks lose money, they tend to panic and cut back on their contributions or, stop contributing all together. This is not smart. Instead, during times like this, you should actually contribute MORE to your account. There are two reasons for this:

"First is that you will need to add more money to your retirement savings to make up for any loss of value. Stopping or reducing your savings during times of poor investment performance will only make your ultimate outcome - the amount you will have saved/accumulate at retirement - worse.

"Second, when the investment falls in value and you contribute more, you will be buying the shares of the funds at lower prices, and therefore, you will buy more shares. When the funds recover, since you will have more shares, you will experience more growth in your account than if you did not increase your contributions," Martin explains.

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