MONEY

How your 401(k) stacks up

If your 401(k) is really full of losers, then you might consider dumping it for an IRA. But do a status check first.

Question: I‘m already putting enough in my 401(k) to get the maximum company match, but I’m thinking about contributing more. I suspect, however, that the funds in my 401(k) are not top performers. Would I be better off instead putting my extra savings into a traditional IRA with better performance? -Dmitriy Tsyganyuk, Kenosha, Wisconsin

Answer: If I were you, the first thing I would do is take a closer look at the fund lineup in your 401(k). You say they’re not “top performers,” but what exactly does that mean?

That they weren’t at the top of some magazine’s or newspaper’s quarterly or annual list of funds with the highest returns? That they didn’t rank the highest among funds in the same category? Are you taking risk as well as raw return into account?

I mention this because you may be setting a standard that’s not only unrealistic, but may lead to subpar long-term results. Funds that are leading the pack today are often laggards tomorrow. So by buying a fund because it’s in the limelight now, you could be jumping in at an inopportune time.

Besides, research shows that when it comes to building a 401(k) balance that will be large enough to support you in retirement, consistent saving and creating a well-diversified portfolio are more important than superior fund picking. So I wouldn’t get obsessed about assuring that the funds in your 401(k) plan – or anywhere else for that matter – are chart-toppers.

Status check

I recommend you find out how the funds in your 401(k) lineup have ranked versus similar funds over a variety of periods – say, one, three, five (and, if possible) 10 years. If the funds in your plan are retail mutual funds that also have shares available to the public, you can check out their performance in the Funds section at Morningstar.com. And don’t forget to look at the risk side of the equation as well as return.

If the funds in your plan are proprietary or institutional funds not listed at Morningstar, you can get returns from your plan’s web site, your 401(k) statement or from the investment firm that oversees the plan and then compare the results to the relevant category averages (large-cap, small-cap, whatever) at the site’s Fund Category returns link.

If your funds consistently rank in the first quartile, or even upper half of similar funds, then they should likely provide all the return you need to build a decent nest egg during your career.

If doing this comparison reveals truly bad performance, however, then you might want to follow through with your plan to invest your extra savings in an IRA.

Going the IRA route

You say you want to do a traditional IRA. I assume by that you mean a deductible IRA, which gives you pretty much the same tax benefit as your 401(k). You might, however, want to consider doing a Roth IRA. You’ll forego the immediate deduction, but you’ll be building a pot of savings that you can draw on free of taxes during retirement.

This assumes that you’re eligible for a traditional IRA or a Roth IRA, which you can easily check by going to this IRA calculator. If that’s not the case, you would still have the option of doing a nondeductible IRA. But unless your 401(k) funds are really horrible (and I mean real losers), it would make little sense make a nondeductible IRA contribution when you can invest pre-tax dollars in your 401(k).

If you do decide to put your extra savings into a traditional or Roth IRA, your goal should be to create the best overall portfolio that you can from the choices available within and outside your 401(k). So, for example, if small-cap funds in your 401(k) are relatively weak, then do as much of your small-cap investing as you can in the IRA.

Initially, at least, you may not be able to pull off this strategy for full effect. After all, you only put up to $5,000 in an IRA this year (plus an extra $1,000 if you’re 50 or older). So if you have, say $50,000 in your 401(k) and it’s the large-cap offerings in your 401(k) that are inferior, you wouldn’t want to put your $50,000 401(k) balance in small-caps and have only the $5,000 in your IRA in large-company funds. That would leave you dangerously overweighted in volatile small-company funds.

So the best course is to start with the asset allocation that you feel is appropriate for your age and risk tolerance and create the best overall portfolio you can given the choices available in both your 401(k) and IRA accounts.

A final note: A big advantage of your 401(k) is that once you sign up, your contributions flow in automatically from your paycheck. So to assure your extra savings actually make it into your IRA, consider duplicating this arrangement by having the fund company automatically transfer money from your checking account into your IRA each month.

Otherwise, you may end up spending your extra dough and up with a smaller nest egg than if you had just funneled the extra bucks into your 401(k), lousy funds or no.

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