Optimize Your 401(k): Seize Opportunities, Avoid Pitfalls, Build Wealth-and Make Millions

Part I

Begin to Win,

the Basics Within

Chapter 1

Common Features of Retirement Plans

This chapter provides important background on the types of retirement plans offered in the private sector (excluding government-run plans) and their key features. This general overview will facilitate understanding the material in later chapters, which will go into much more detail.

Our focus here is primarily on defined contribution plans. In these plans, contributions are made to the participant’s account by the employee, the employer, or both. Once the contributions are made, the participant decides how to invest these funds. Almost every plan offers a choice of investment options, typically an assortment of mutual funds. In some plans, the employer’s company stock is offered as an investment option. The participant bears all the investment-related risk in a defined contribution plan and is not guaranteed a benefit at retirement. Generally, taxes are paid upon distribution, except for Roth accounts.

In defined benefit plans, participants are guaranteed a benefit payable as an annuity for their life, normally beginning when they retire. The employer is responsible for setting and managing the funds; distributions are generally taxable. Defined benefit pension plans have been decreasing in popularity in the United States for years.

While plan features may vary significantly, federal law, the Employee Retirement Income Security Act (ERISA), has established minimum standards and procedures for nearly all plans. While your employer is not legally required to offer a plan, it must follow these minimum standards and procedures if it does.

Types of Defined Contribution Plans

The widely offered traditional 401(k) plan is a defined contribution plan that provides significant tax advantages for the employer. Its name comes from the Internal Revenue Code section governing these plans. Employees can contribute a portion of their salary to their accounts through payroll withholding, and many employers then match some or all of the employee contributions, although a match is not required. The terms of the match are covered in the plan document, which the employer controls. The employer match is my favorite 401(k) feature because it’s like getting free money. You will learn to take full advantage of this feature, which can sometimes be tricky. Also, earnings are not taxed while they remain invested in the plan. Employee and employer contributions are subject to limits imposed by the Internal Revenue Code and the plan terms.

Roth 401(k) plan contributions are similar to traditional plan contributions, and most employers offer both traditional and Roth. The difference is generally in the way they are taxed. A traditional 401(k) reduces the employee’s income taxes in the year contributions are made because the earnings that were withheld and deposited directly into the 401(k) account aren’t subject to tax. However, those contributions and earnings are taxed when the money is ultimately distributed from the account to the participant.

Roth contributions, on the other hand, are made with after-tax amounts, meaning that all of the employee’s earnings are considered fully taxable, and the taxes on those earnings are deducted from the contributions before they are sent to the Roth 401(k). However, distributions later withdrawn from the account, usually upon retirement, and associated income earned on the contributions over the years are tax-free.

In 2024, the maximum an employee could contribute each year to any 401(k) plan, including Roth and traditional contributions, was $23,000. Most 401(k) plans also include a catch-up contribution feature, which allows participants age fifty and over to increase contributions to their 401(k) plans as retirement is rapidly approaching. This feature is a nice second bite at the apple when people can most afford it after they’ve raised their families, settled into their homes, and so on. In 2024, employees could make an additional catch-up contribution each year of $7,500. Therefore, those who are age fifty and over had a total limit of $30,500 annually.

The profit-sharing plan is another defined contribution plan. The employer determines the amount contributed, which is often based on compensation (e.g., 5%) and may vary from year to year. Employer contributions and earnings to this type of plan are taxable to the employee in the year they are withdrawn. This is a fantastic benefit you may be fortunate to enjoy⁠—more free money!

Tax shelters are often mentioned in the news or in advertisements as investment vehicles for the wealthy. However, tax shelters are not only for the rich and don’t have to involve Swiss bank accounts or other shady schemes. Meet the 401(k) retirement tax shelter for everyone: Tax shelters are legal ways for a taxpayer to protect (or shelter) income from taxation.

401(k) and other plans, such as profit-sharing plans and IRAs, allow you to pay taxes later, when your tax rates may be lower after you’ve retired, thereby reducing your tax burden and protecting your income.

Plan Features

Participation: All plans contain rules for determining eligibility and often exclude certain classes of employees, like hourly or commission based. Employees may be legally excluded as long as several technical rules are met. You should review your plan’s summary plan description (SPD) to determine its rules and see if you are covered. Even if you are covered, the plan may require you to be at least age twenty-one and have a year of service (typically, no more than five hundred or one thousand hours are required in the year) before participation can start. A plan may not exclude an employee who has reached a maximum age (e.g., sixty).

Many 401(k) plans automatically enroll participants. This means employees do not have to opt in to participate; instead, it allows them to opt out if they choose not to participate. Most employees will take no action and opt into the plan by default, thereby building their retirement funds by doing nothing.

Vesting: Vesting means you own the contributions and earnings in your retirement account and cannot forfeit them. In a 401(k) plan, you are always 100% vested in the contributions you make and the earnings on those amounts. But in most defined contribution plans, such as profit-sharing and 401(k) plans, you will likely have to work for several years before becoming fully vested in your company’s contributions, including 401(k) matching contributions and related earnings. The vesting schedule is described in the plan document.

A variety of different vesting schedules are commonly used. One involves immediate vesting in company contributions after three years of service. This is known as cliff vesting because you aren’t vested in any portion before working for three years. Alternatively, a graded vesting schedule may apply, where you become at least 20% vested after two years, 40% after three years, 60% after four years, 80% after five years, and 100% vested after six years. A two-year vesting schedule, in which you are not vested in any portion before working for two years, is sometimes provided in 401(k) plans with automatic enrollment features, where the employer must make a minimum contribution, which becomes fully vested after two years of service.

A plan can always vest company contributions more quickly; the above schedules are the maximum number of years that may be required under applicable law. Hopefully, yours will vest quickly.

Importantly, when you become vested, you own the portion of your benefit that is vested, but you still may not be able to withdraw it from the plan until later. Your plan and applicable law control when you can withdraw your benefits.

Withdrawing your benefit: The plan document explains when a distribution, also known as a withdrawal, can be made (e.g., at retirement) and the available distribution options (e.g., lump sum). This information is also contained in the SPD, which explains the plan document in plain English and is far easier to understand. Reading of the SPD should be required for all plan participants! I am half joking, but it is an excellent resource to learn about the money you worked so hard for.

You must generally start withdrawing your retirement benefits no later than April 1, following the calendar year you attain age seventy-three (seventy-five starting in 2033, which affects those born in 1960 and later) or the year you retire (if later than those ages). Beyond retirement, there are sometimes other events, such as termination of employment, that may enable you to take a distribution under some plan types (401(k) and profit sharing) but not others (pension plans). 401(k) plans often allow distributions while employed if the participant reaches age fifty-nine and a half or incurs a hardship, and most allow participants to borrow money from their accounts. Profit-sharing plans may allow distributions while the employee still works at the company once they achieve a specified number of years of service.

Required information: Depending on the type of retirement plan and when you meet the plan’s eligibility requirements, you should receive several documents. These include an SPD, enrollment package, beneficiary designation, and salary deferral election form. The plan must also provide certain written notices, some automatically and others upon request. Online notices are permissible by law if certain requirements are met.

Filing a claim for benefits: All plans must have a reasonable procedure for processing a claim for benefits. Your plan’s claim procedures are explained in the SPD. If you have a problem regarding your benefits, such as whether the amount is correct, you can file a formal claim under the plan’s claim procedure rules.

Seeking help: Besides creating rights for plan participants, ERISA imposes duties on people who use their discretion or judgment in operating your plan. These fiduciaries have a legal duty to act prudently and in the interests of plan participants and beneficiaries, and they generally include investment managers, trustees, and plan administrators. If you have questions about your plan, the first place to start is with your SPD. If you need additional assistance, you should contact the plan administrator. The SPD should provide information on how to do this. See appendix B for more information.

Plan mergers and terminations: If your company merges with another company, your plan will likely change. Common changes include investment options and recordkeeper changes.

If your plan is terminated, all affected participants become fully vested, regardless of the plan’s vesting schedule.

Summary

Most private-sector retirement plans are defined contribution plans.

401(k) and other retirement plans are legal tax shelters that help you defer your taxes and protect your income.

The SPD describes your plan’s participation, vesting, withdrawal, and other important features.

Chapter 2

Building Your Investment Knowledge Base

Bank accounts can be a safe haven for your savings, but the modest returns will be insufficient for almost everyone. While billionaires may succeed with this approach, most of us require investment options with much higher returns to achieve financial flexibility and a comfortable retirement. This is where 401(k) plans come into play, offering a crucial solution to this financial challenge. They are a popular choice for many, typically offering a diverse range of investment options carefully selected by your company or an external advisor. This variety allows you to tailor your investments to align with your financial goals, and this chapter will introduce you to some of the most popular options and key topics. Important investing concepts include risk mitigation, asset allocation, diversification, domestic stocks, international stocks, bonds, and index investing.

The US Stock Market

When you buy a share of stock, you receive and own a small piece of a company. This type of investment is often called equity because equity means ownership. If the company does well, it is rewarded, and so are you as an investor or owner in the form of returns. On the contrary, if your investment does poorly, the value of your stock diminishes, and you can lose part or all of it. Stock returns measure the gain or loss from a stock investment over a specified period. These returns include increases in the stock price, known as capital gains, and dividends, which are a distribution of profits to the investor. For example, if I purchase a share of stock for $40, sell it in a year for $60, and receive a $2 dividend during the same year, the capital gain is $20 ($60 − $40). But in this case, my annual return is 55%⁠—the capital gain plus the dividend divided by the initial investment ($22 ÷ $40).

Investing in stocks has historically offered high returns and outperformed other investments, such as bonds or savings accounts, over long periods. It has been one of the greatest wealth-generation opportunities over the long term and has always increased in value. This is why it is important to be optimistic and have hope for your financial future.

Historical stock market returns, such as the S&P 500 index, show this potential. This index, which began in 1926, was initially named the Composite Index and started with only 90 stocks. It has since become a barometer or benchmark for tracking the performance of the United States equity market, and in 1957, it was expanded to include 500 stocks. Historical records indicate that the average annual return from 1926 through 2023 was approximately 10%.¹ Over the last four decades, the average yearly return has done even better, averaging over 11%. This index represents approximately 80% of the US stock market’s value or capitalization. A company’s market capitalization, simply put, is its value based on the price of the stock multiplied by all outstanding shares.

The S&P 500 index has increased considerably over the decades and will almost certainly continue to rise over long periods (ten or more years). Consider this: The S&P index was valued at nearly $40 at the end of 1957 and $4,769 at the end of 2023.² The average rate of return during this period, including dividends, was over 10.5% per year.³ By measuring the stock performance of the 500 largest public corporations in the United States, this index provides a secure and reliable representation of the health of the US stock market, thereby serving as a solid basis for future investment. The index calculation is determined by the market capitalization of the companies in the index, divided by an index divisor (determined by the S&P Dow Jones Indices organization).

Corrections and Crashes, Oh My

Market corrections and crashes are expected, have happened before, and will continue to occur. The S&P 500 has experienced fluctuations yearly for the last ninety-four years, with 27% of those years showing negative results and 73% showing positive returns. Historical evidence indicates that a longer investment period, spanning market highs and lows, generally increases the likelihood of a positive outcome. For example, 94% of ten-year spans have produced positive returns over the past ninety-six years ending in 2023.⁴ Investors who weathered occasional declines in stock prices were historically rewarded for their patience and long-term perspective by earning back those losses and experiencing net gains. Investing in the market may be a rocky ride in the short term, but it has consistently increased over time.⁵

The data from Crestmont Research, a firm that provides financial insights and financial market education services, is even more persuasive in demonstrating the importance of time in investing.⁶ They studied the rolling twenty-year total returns of the S&P 500, including dividends, from 1900 to 2022. All 104 rolling twenty-year periods experienced positive total returns. This means that whether an investor bought at the market peak or a low point, they would have seen a positive return by simply holding on to an S&P 500 index for twenty years. This extensive data supports a long-term optimistic outcome for the S&P 500 index.

The Dow Jones Industrial Average (DJIA) is another stock market index and includes a much smaller number of companies than the S&P. It follows thirty blue chip US companies, the largest and most well-known companies in their industries. Intended to serve as a proxy for the US stock market, the Dow has tracked closely with the S&P.

The elephant in the room is a market crash or correction, during which your stocks drop significantly in value and ruin your dreams. The Dow, for example, closed at 589.64 after a market crash in December 1974, losing about 45% of its value between January 1973 and December 1974.⁷ Although it had grown to over 18,000 by the end of 2014, averaging over 12% growth rate annually, investors had to learn the meaning of patience.⁸

If a crash occurs close to or during your retirement, you may be forced to sell a portion of your equity portfolio when it drops in value to meet your financial lifestyle needs. This leaves less of your portfolio intact to recover when the market rebounds, which is more likely if you have invested a significant portion of your portfolio in equities. Looking at this another way, retirement can last for several decades, and you need to protect against running out of money, so investing in equities is important because they have greater growth potential and the ability to beat inflation than fixed-income returns⁠—even if that means needing to deal with the volatility that comes with the territory. Below, we discuss asset diversification to help manage inevitable market fluctuations.

Timing the Market Is a Recipe for Disappointment

Unfortunately, many individuals lose money in the stock market because they seek quick profits and believe they can accurately predict its movements. They try to select individual stocks or funds to make substantial gains quickly. Instead, this approach often leads to buying at high prices and selling at low ones, which is different from conventional