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There's no worse feeling than watching something with real promise fall short of your expectations. For me, that describes 401(k) plans perfectly -- a well-intentioned tool that has turned into a big disappointment for millions of investors.

What might have been
In theory, the 401(k) plan gives workers a huge advantage in saving for retirement. It gives you a tax break when you contribute, providing a strong incentive to participate. When employers also help out with matching contributions and profit-sharing programs that put additional money into workers' plan accounts, it becomes that much easier to save and invest enough to live out your golden years in comfort.

Moreover, 401(k) plans have the potential for complete investment flexibility. There's nothing keeping a plan from letting participants invest in nearly anything they might want. Technically, you could buy the same shares of stocks, ETFs, and mutual funds within your 401(k) that you own in your other accounts -- but with the benefit of tax deferral.

Falling short
Unfortunately, in practice, 401(k) plans haven't reached their full potential. Here are just a few of their shortcomings:

  • Some employers don't bother adding a match or profit sharing for their employees, giving workers less incentive to participate on their own behalf. Especially during tough times, some companies suspend matches or profit sharing.
  • Most 401(k) plans don't offer anywhere near the range of investments you can find elsewhere. Rather than having access to the full range of stocks and ETFs, the bulk of plans limit their participants to mutual funds.
  • Even a 401(k) plan that only offers mutual funds could give investors good options. But too often, employees have only a few funds to pick from, and they're often not the funds you'd pick for yourself -- as they come with high fees, poor performance, and inexperienced management.

So what should you do if you're stuck with a plan you can't stand? Does it make sense just to give up and invest elsewhere, or is there a way to make the most of it and still get some of the benefits of a 401(k)?

Four tips for 401(k) choices
Usually, unless a plan is really bad, it's worth trying to salvage it -- at least to some extent. In deciding whether to participate and how much to contribute, keep these four ideas in mind:

  • Be tax smart. Remember, a big benefit of 401(k) plans is tax deferral, so if possible, use your 401(k) to make tax-heavy investments. That includes bond funds, as well as stock funds with tons of high-dividend payers. Then, outside your plan, you can invest in a growth fund, or directly in shares of non-dividend stocks for diversification -- they won't generate as much taxable income.
  • Get the match. Typically, employers only match a small amount of worker contributions -- 3% is a common amount currently. So while contributing what you have to in order to get your free match usually makes sense for all but the most expensive plans, don't lock up any more of your funds in a high-cost 401(k) than you have to.
  • Remember the rollover. The worst damage from a bad 401(k) plan comes from the annual drag on performance that high fees create. So as soon as you switch jobs, get that money out of the 401(k) and into a rollover IRA.
  • Pick the best available. As long as you have outside funds to invest elsewhere, your 401(k) doesn't have to be perfectly diversified. If the best choice is a low-cost index or lifecycle fund, put all your money in it -- and use outside savings to spice up your overall portfolio with small caps, international stocks, and other asset classes.

Sure, 401(k) plans might not have lived up to your wildest dreams. But even a disappointing plan can still serve a valuable purpose in your retirement investing. So before you give up entirely on your 401(k), take a close look at whether you can salvage something out of it.

This article was originally published on Dec. 17, 2008. It has been updated by Dan Caplinger, who doesn't own shares of any stocks mentioned in the article.

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