7 Steps to Maximize Your 401(k)

In this episode of Motley Fool Answers, Alison Southwick is joined by Certified Financial Planner Robert Brokamp of The Motley Fool to bring you some tips and tricks to get the most out of your 401(k) contributions. Alison begins the show with a fun trivia game with Robert playing versus producer Rick Engdahl. Next, Robert and Alison tell you about the origin of the 401(k), how you can take full advantage of the plan, and much more.

Plus, get a preview of what's coming up next on the mailbag and how you can send in your questions.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Oct. 13, 2020.

Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick, and I'm joined as always by Robert Brokamp, personal "fly nets" expert [laughs] here at The Motley Fool.

Robert Brokamp: [laughs] Yes, this is the day after the Vice Presidential Debate.

Southwick: That we are taping. So, these are the jokes, everybody. All right. In this week's episode we're talking about seven ways to make the most of your 401(k); all that and more on this week's episode of Motley Fool Answers.

[...]

Brokamp: So, Alison, what's up?

Southwick: Well, Bro, it's been a while since we just had some meaningless stupid fun on the show, so guess what, today is the day.

Brokamp: Woohoo!

Southwick: Yeah, I know, it's exciting. Because instead of me essentially giving you a book report on something I find interesting and remotely tangential [laughs] to money, I'm going to make you play a game about something I find interesting and remotely tangential to money. Yeah, Rick, put your phone down, this one's for you.

Brokamp: All right.

Southwick: Amazon (AMZN -1.14%) Prime Day! As our listeners are listening to this, today is the kick off to Amazon Prime Day. As we are taping, though, of course as we mentioned, it's something in the future and millions of Americans are awaiting with thumbs of twitchy purchasing anticipation. So, Prime Day was supposed to happen back in July this year, but because of the pandemic they decided to postpone it to Oct. 13th and 14th. You can expect discounts on over 1 million items. Is it stuff you need? Who cares, you'd be wasting money not buying it.

So, let's take a moment and see how much you two know about Prime Day. Are you ready?

Brokamp: I'm ready to be embarrassed, yes.

Southwick: Rick, are you ready?

Rick Engdahl: Yeah. Anything Amazon, I'm on it.

Southwick: First question. The first Amazon Prime Day was in 2015 to celebrate the company's 20th birthday. They were estimated to have made $900,000 in sales. Well, how much did they do in sales for Prime Day the following year in 2016? And we could do closest without going over.

Brokamp: So, they made under $1 million the first year.

Southwick: Uh-huh.

Brokamp: Uh! [laughs] $1. No, I'm just kidding. I'll say $3 million.

Engdahl: I'll say $500 million.

Southwick: Well, supposedly, in sales they made over $1.5 billion.

Brokamp: See, I told you I'd be embarrassed.

Southwick: [laughs] That's the whole point of this. Rick --

Brokamp: To embarrass me. [laughs]

Southwick: Yes, I mean, Bro, you get to be so smart-sounding on all the other episodes, because you know so much.

Engdahl: Because he does research.

Southwick: Right, because he does research. And so ...

Brokamp: Well, and I'm not -- like, anything about buying stuff, like, I'm the last person to know anything about retail-oriented things. But anyways, go ahead, I'll keep making embarrassing guesses. Congratulations, Rick, at the first point.

Southwick: OK. So, if that's how much they made in 2016, how much did they sell last year, in 2019? So, $1.5 billion in 2016, how much last year, in 2019?

Brokamp: You can go first, Rick, if you want.

Engdahl: $5 billion.

Southwick: Bro?

Brokamp: $4.9 billion.

Southwick: $7.2 billion.

Brokamp: [laughs] Oh, my God! Oh, boy!

Southwick: Yeah, $7.2 billion, that's a lot of do-re-mi, but that's not the biggest shopping day of the year on this big stupid globe. Which retailer is actually responsible for creating the biggest single shopping day of the year? Multiple choice: Mercado Libre, Alibaba, Google, [Alphabet] or Baidu?

Brokamp: I would say No. 2, Alibaba.

Engdahl: Yeah, I'd say that too. I'll say, Baidu, just to be different.

Southwick: Just to be different. All right. Well, guess what, Bro, you got it. Because it's Alibaba with their Singles Day specials. Have you heard of Singles Day?

Brokamp: I don't believe I have.

Southwick: Well, guess what, you're about to learn a lot more about Singles Day.

Brokamp: Outstanding.

Southwick: So, Alibaba's Singles Day in 2019 was estimated to rake in $38.4 billion in sales. Yes, that's 5X Prime Day. In 2019, sales started at midnight, and Alibaba reported selling $1 billion worth of goods in the first 68 seconds.

Brokamp: Geesh! Goodness gracious.

Southwick: That's bananas. This is tough, but I think you're smart enough to figure it out. What day does Singles Day fall on in China?

Brokamp: The start of the Chinese New Year.

Engdahl: Valentine's Day.

Southwick: So, Rick was a little warmer, but you're both wrong. It's on Nov. 11. So, 11/11, get it? Because of all those 1s. According to Vox, Singles Day was started as an unofficial celebration of a person's singledom. It was founded in the '90s by Chinese university students as an anti-Valentine's Day. The date was selected 11/11, as it is fittingly full of ones, to symbolize solo living. Alibaba latched onto the idea of telling Chinese consumers to embrace your singleness and treat yourself, buy something, get yourself a gift.

Speaking of treating yourself. What is the thing Alison keeps buying on Amazon that is bringing her the most joy during this time of awful? Is it roller skates, erasable pens, various and sundry artisanal hard seltzer delivered through Whole Foods or dominoes and other board games?

Brokamp: Hmm... I'd like to say board games, but I'm going with the seltzers.

Engdahl: Yeah, I'm going with seltzers, too.

Southwick: So, yes, I did buy roller skates as an adult, and I've been roller-skating with my daughter.

Brokamp: Outstanding.

Southwick: I know. And I have been trying every new hard seltzer that hits the market, and I can tell you some are breathtakingly undrinkable. And we have been playing a lot of dominoes at my house, but the thing that is bringing me [laughs] the most joy is my friction erasable pens made by Pilot. They are not a sponsor; I am endorsing these because I love them. They are the gel pens, not the clicky ones, and they are just a delight, because they are entirely erasable because it uses heat to make them go away. And I just love them so much. I use a different one every day, and this is what it's come down to.

Now, if you'll excuse me, I'm going to go lace up my skates, pound a hard seltzer and destroy my 7-year-old daughter at a game of dominoes. That's not true, she always beats me. And that, Bro, is what's up.

[...]

Brokamp: Ted Benna was sitting in his Pennsylvania office on a Saturday, working on a project for one of his clients. He was looking at a law that was passed in 1978, and it occurred to him that it could be interpreted such a way as to allow employees to make pre-tax contributions to a savings account. And pre-tax was pretty important back then, because the highest tax bracket was 70%. Furthermore, for it to work, enough lower-paid employees had to participate, because by law, these types of plans couldn't just benefit the higher-paid folks. So, it might be possible that employers could match their employees' contributions as an incentive to get them to participate.

Now, this 1978 law was not written for this purpose, but it also didn't explicitly prohibit it. So, Mr. Benna shared the idea with his partner and they shared it with one of their clients, who just happened to be a cabinet member in the relatively new Reagan administration. This cabinet member put Mr. Benna in touch with the Treasury officials in charge of the regulations that govern this law. He got the government go-ahead, and a new savings account was born, one named after Section 401 Subsection K of the IRS Code. In other words, in Mr. Benna's words, the birth of the 401(k) was a fluke. It was not intended to become the No. 1 way for millions of Americans to save for retirement. Yet, here we are.

By the way, the client that Benna first proposed the 401(k) to, which was a bank, turned it down. They didn't want to try something that had never been done before. So, the actual first 401(k) was with Benna's own company, but they didn't want to do the investing, so they turned to another Pennsylvania company, which at the time was just six years old, that company being Vanguard.

By 1982, Benna's company was administering 50 plans with the help of a computer from a company named Wang that cost $65,000. So, we've come a long way. And of course, since 1982, the 401(k) has just taken off.

For what it's worth, Mr. Benna has very mixed feelings about his creation. He thinks that in many cases 401(k)s have become too complicated and too expensive. And indeed, when you look at, sort of, the whole defined contribution system, which includes 401(k)s, as well as 403(b)s and the Federal Thrift Savings Plan and the Employer Sponsored Plan, basically they require that employees become financial planners and investing experts in their spare time, right? Each participant has to determine which type of account to choose, traditional or Roth; how much to save; how to invest that savings; and then how much you can take out in retirement?

And then another big complaint, of course, is the captive nature of the system. Employees are stuck with the plan chosen by their employer with limited control over all the costs and investments. But still, while not perfect, contributing to your employer's plan year after year can indeed provide a foundation upon which to build your retirement, especially if you follow these seven recommendations. Take it away, Alison.

Southwick: And the first one is, save enough and take full advantage of the match.

Brokamp: Right. So, everyone should know this one, of course. You got to save to benefit. How much you should be saving for retirement depends on an awful lot of factors, such as when you want to retire; whether you're covered by a pension --  some people still are; and how much you've already saved. But a good rule of thumb is that workers should aim to save 15% and even higher if they're getting a late start on saving for retirement. Fortunately, for the majority of workers, they don't have to come up with that 15% all on their own, most plans do offer a match with the most common formula being $0.50 for every $1 saved up to a savings rate of 6%. So, for these workers, they need to save 12%, the employer kicks in 3%.

Unfortunately, most people aren't saving that much. The typical average is anywhere between 8% to 12% depending on which plan you're looking at. And in fact, up to a third of employees don't even take full advantage of the match. So, at the very least you have to be grabbing that free money and most people should be saving more.

Southwick: All right, next one, choose the best investments. Oh, you make it sound so easy, Bro; just choose the best.

Brokamp: [laughs] It's very easy. Anyways. One of the biggest drawbacks to most 401(k)s is that the investment choices are limited to a collection of mutual funds. The situation has improved significantly over the last 20 years or so as more plans now offer index funds and target date funds, but most plans still include at least some underperforming, actively managed funds. And also, I should say that, while I'm a big believer in target date funds for the hands-off investor, they tend to be more conservative than what the typical Motley Fool listener or reader would choose on their own.

So, you have this collection of actively managed funds in front of you, here's how to evaluate those plans. Look up the fund on Morningstar.com and you have to make sure you use the same ticker as the fund in your plan. Funds often have multiple share classes with the main difference being the cost. So, make sure you're using the ticker which will be five letters, the last one being an X, and not just searching by the fund's name.

Okay. So, once you find the fund on Morningstar, click on the "performance" tab, scroll down to the trailing returns, and there you'll see its returns over various time periods: one, five, 10 years, and 15 years if the fund has been around that long. Most importantly, you're going to see the fund's percentile rank. That compares its performance to other funds with similar types of investment objectives. So, let's say, for example, you're checking up on your U.S. small-cap value fund, the percentile rank measures how it fared relative to all the other U.S. small-cap value funds. And this is crucial, because it makes sure that you're making an apples-to-apples comparison. The lower the number, the better. So, for example, if the fund's percentile rank is 25, then it has performed in the top 25% and outperformed the other 75% of those types of funds for that time period. And you should be looking at a longer time period if you can, at least three, five years, ideally 10, if the fund has been around that long.

So, all that said, you can have a fund that outperforms most of its peers, but still underperforms an index fund. And in that case, it might be time to just ditch the actively managed fund for the index variety if you can. I should add that it's possible that your 401(k) will have an investment fund that basically doesn't have tickers. And these are most often collective investment trusts that have been designed specifically for that plan, generally you'll find these in very large employers, and actually they're pretty good. So, if you have these in your plan compare their fees and performance to an index fund with a similar investment objective.

Southwick: All right, No. 3, choose stocks or other funds if you can.

Brokamp: Yeah. I would say, one of the most disappointing aspects of the defined contribution system for Motley Fool listeners and readers is that most 401(k)s don't allow participants to pick stocks. However, if your employer is among the approximately 20% or so that does offer a side brokerage account, then your investment choices are greatly expanded. With that side brokerage account, you can buy individual stocks, bonds, ETFs, and probably choose from among thousands of other mutual funds, just like you would with a regular old discount brokerage account.

I will say about mutual funds, though, it's important to see whether you're going to have to pay a commission. So, you might have a side brokerage account or even just a regular old discount brokerage account outside of your 401(k) that doesn't charge commissions on stocks, for example, but for some funds you might pay a commission of up to $75 every time you buy the funds. So, just make sure you are aware of that. The funds that don't charge a commission will often have NTF next to it listed on the site. NTF stands for No Transaction Fee. I will say, though, that sometimes these funds have a higher expense ratio. So, if you're putting a lot of money into a fund, it actually might make sense, and you really love that fund, to pay that $75 commission rather than paying a higher expense ratio year after year.

Southwick: I feel like you are among a small class of people who would actually use the phrase, I really love this mutual fund. [laughs] That's a passion that runs deep for a small slice of this country, and you're one of them.

Brokamp: You know what I would say, I would say -- what I more likely say is, I really love this fund company because it treats its shareholders very well. I would throw, like, the Vanguards, and Dodge & Coxes and those types of companies in that category.

Southwick: All right, No. 4, coordinate your 401(k) allocation with your other accounts.

Brokamp: Yeah. So, ideally you at least have a couple of good fund options within your 401(k), and you can choose those to play that respective role in your asset allocation, and then you sort of round out your portfolio with all your other accounts, you know, your taxable brokerages, your IRAs or even your spouse's employer sponsored account.

So, for example, let's say your 401(k) is a particularly good international stock fund and small-cap fund. You could overweight those in your 401(k) and then you focus on other assets in your other accounts. Now, one area, actually, where defined contribution plans often offer above average choices are in, sort of, the cash- and bond-like investments, and this is especially true in 403(b) plans. You know, these days you're not getting anything on cash, but some defined contribution plans do have cash- or bond-like investments that are still yielding 1%, 2%. So, that's one way in which you might favor your 401(k) for that type of investment.

Many Motley Fool members and employees, myself included, like a mix of index funds and individual stocks, and since almost all 401(k)s offer index funds, many Fools use their employer plans for their index portion of their portfolios and then they use their other accounts for other types of investments. And I would just add that this, sort of, raises a broader point, like, when considering your asset allocation, it's important to focus on your entire portfolio and not just one account. And one excellent way to do this is through a tool like Morningstar's Instant X-Ray, which is awesome, because you just enter all your investments, your stocks, mutual funds, ETFs, and it actually peers into the fund holdings to determine how much you have in each company, sector, and asset class, which I think is pretty interesting.

Southwick: No. 5, move your money, if you can.

Brokamp: Yes. And we highlighted this in a recent episode, but I was going to point it out again. If you have a less than excellent 401(k), roll over the money to an IRA as soon as possible. And here are three ways that you can do it. No. 1, you've left your employer. If you've switched to another job or retired, you can definitely transfer the money. No. 2. Most plans offer in-service distributions, which basically lets you move money even though you're still working with the company, though, it does depend on whether the plan allows it in certain criteria, the most common is that employees can transfer at least some money out of the plan once they reach 59 1/2. Just check with your plan to see if this is available to you.

And then the third one, which we've talked about many times this year, is COVID-related hardships, that thanks to the CARES Act, if you have suffered any of these hardships, and there's a specific list of them on the IRS website, you can move $100,000 out of your retirement accounts. You do owe taxes, you avoid the 10% penalty, but if you put that money back into another retirement account within three years it's like it never happened. So, this is a way to get money out of a bad 401(k) and into an IRA. Just make sure that you're following all the rules. If you have an accountant or someone like that, call them to make sure you're doing it properly.

Southwick: No. 6, contribute beyond the max, if your plan allows it.

Brokamp: So, every year, you've probably heard about the contribution limits with 401(k)s. In 2020 that limit is $19,500 with an additional $6,500 if you'll be 50 or older by Dec. 31. But there's actually another, sort of, all-in limit, and this year it's $57,000; $63,500 for the 50-and-older crowd. This includes everything that goes into account, so that's what you put in and the employer match. But if your plan allows it, you can make additional, what are known as, after-tax contributions on top of that. And about 40% of plans do allow this. Now, don't confuse after-tax contributions with Roth contributions, which are after-tax. but that's not what this is talking about. Roth grows tax-free; these after-tax contributions grow tax-deferred, i.e., you don't pay taxes until you make withdrawals. But you might even be able to get around that by doing an in-plan conversion again if your plan allows it. So, I'm not going to go into all the details, since not everyone can do this and it's really only for the people who just want to be supersavers. But to learn more, do an online search on the terms "after-tax 401(k)" or "the mega backdoor Roth" which is ...

Southwick: [laughs] ... 50% of our listeners were just like, wait, there's a mega backdoor Roth?

Brokamp: Yes. Google it, you'll find out all you need to know.

Southwick: And that is the sound of millions of computers across the nation googling it right this second. Mega backdoor Roth. Oh, wow! someone had good PR when they created that term.

All right. Finally, seven, advocate for a better plan.

Brokamp: Yeah. So, everyone at your company, you, your boss, the HR department, you're all in the same 401(k) boat. If the plan has high cost, subpar investments, limited flexibility, then everyone's retirement prospects suffer. So, do some research, gather data, and recruit allies that can maybe help you persuade your employer to improve your company's 401(k), maybe even replace it.

A couple of good resources for this. Christine Benz at Morningstar, who is one of my all-time favorite personal finance writers, wrote an article in September called A Checklist for Lobbying for a Better 401(k). So, that has some great information. Over on Fool.com, there's an article called, Dear Boss: Fix Our 401(k) written by Dayana Yochim, founding member of the Answers team and composer and arranger of our theme song. So, search on Fool.com for Dear Boss: Fix Our 401(k), as a sample letter, I will say the article was written several years ago, so some of the numbers are outdated, but it gives you a good framework for how to maybe talk to your boss about improving the plan.

Over the years, I've heard from readers and listeners who have successfully convinced their employers to at least add features to their 401(k)s, if not change the plan altogether. There's no harm in asking. And if you're successful, your future retired self, and those of your colleagues, will thank you.

[...]

Southwick: Well, Bro, that was great. Maybe you can come back on the show again. That was fantastic ...

Brokamp: If you'll ask me, I'll do it.

Southwick: Before we go, I just want to say a quick "hello" and "thank you" to Julia and David. They're a couple of Answers listeners who were kind enough to sit down on a Zoom call with me today and share their investing experience. Truly, lovely people with great stories. Thank you, again.

All right, that's the show. It's edited [...] something by Rick Engdahl. Our email is [email protected], drop us a line, ask us a question, we probably have a mailbag episode coming up, so we'll try to get to them as we try. We try, Bro, we try. I know you feel bad that we don't get to answer all the questions, but we try.

Brokamp: I do. I'll give you a preview, because the next person who is going to help us on our mailbag is Jim Mueller, who's our resident options expert. If you've ever had questions about options you could send us those, but keep them general, nothing too fancy. But Jim is going to join us and talk a little bit about investing in options and all kinds of good stuff.

Southwick: For Robert Brokamp, I'm Alison Southwick, stay Foolish everybody.