Every retirement plan you own has a spot for you to designate a beneficiary. It seems like a simple problem right? Just pick someone you trust and everything will be okay. Couples name their spouse, singles name their parents or their children, everyone can think of at least one person they’d want to leave their money to and simply put them. Some people neglect to put anyone. Either scenario can be dangerous for numerous reasons and here are a few things to consider.

Beneficiary Rules

The rules of naming a beneficiary are not as simple as they may seem. A prime example is that many pensions and employer sponsored retirement plans (401Ks, etc) require that you name your spouse unless your spouse waives that right in writing. If the plan doesn’t require it, the state might. Other accounts will not let your assets directly transfer to a minor and will require the funds be given to a trustee or guardian instead. Be sure to check those first because they will hold precedence.

Here’s where the fun begins. Selecting a beneficiary, once you get past the laws and rules of the program, comes down to the mechanics.

Selecting a Beneficiary for Employer Retirement Plans

Spouses: If your spouse is the beneficiary, he or she will inherit the assets without paying federal estate or income taxes. However, starting at age 70.5, the spouse will have to start taking the required minimum distributions as mandated by his or her life expectancy. Those required distributions are taxed as income, as they would if you were taking it.

Everyone Else: Any nonspousal beneficiary (that’s what they call everyone else) must cash it all out (bad) within one to five years or roll the funds over to an IRA in a trustee-to-trustee transfer (same thing that happens when you rollover a 401k into an IRA). The rollover option was added effective 2007 but many plans haven’t changed their rules to allow this option, it’s best to double check.

Selecting a Beneficiary for IRAs

IRAs differ slightly from employer sponsored retirement plans.

Spouses: Spousal beneficiaries can just designate themselves as the account owner. There are no additional taxes.

Everyone Else: Everyone else has to cash out over the next five years or take annual distributions determined by life expectancy of either the beneficiary or the decedent, whichever would’ve had the higher life expectancy.

Given the recent Supreme Court ruling that upheld the tax advantaged status of investments such as municipal bonds, you may be tempted to begin investing in these instruments. If you do, don’t invest in them through a 401K or an IRA (either Roth or Traditional). You want to take full advantage of their tax advantaged status by investing in them in a fully taxable brokerage account.

The benefit of municipal bonds is that they are exempt from federal, state and local income taxes if they meet certain qualifications. If you live in Maryland and purchase a Maryland municipal bond, then those earnings are exempt from federal, state, and local income taxes - thus pushing up its yield (because you’d be paying taxes on the earnings of any other investment).

If you invest in those types of securities in a 401K, you lose the tax exempt status because you ultimately pay taxes on distributions in the 401K (the same for a Traditional IRA). If you invested in a Roth IRA, you are still exempt but all appreciation in a Roth IRA is exempt from taxes. You are essentially no longer getting the same advantage and thus not maximizing your yield.

My wife works at a relatively small startup-type company that has a 401(k) plan but offers no employer match. One of the things I had researched was whether it was a good idea to put funds towards a 401(k) plan or if other options were better for her and broke it down to several considerations.

$15,500

That’s how much money you can put, tax-deferred, in a 401(k). What that means is that you don’t pay tax on it today, you defer the tax until you start taking withdrawals in retirement. When you make a $1 contribution, it reduces your income by $1 and you don’t pay tax on that money. The benefit from the 401(k) is that you can invest your tax-deferred money and avoid taxes until retirement. There is no other investment vehicle like that for an employee in terms of magnitude.

The only other similar option would be a Traditional IRA but that has some downsides. First, depending on the rules of your 401(k), you may not even be able to deduct contributions to a Traditional IRA. Second, it shares the same contribution limit as a Roth IRA, which grows tax-free (you pay taxes on the contributions). I recommend taking advantage of the Roth IRA, so a Traditional IRA is almost never an option unless you’ve exceeded the income limits.

Fund Options

If your employer lets you pick from a nice healthy basket of mutual funds or stocks, that’s the ideal. If your employer, such as my first employer, only offers their own private versions of funds then you may be in a tough situation. You might want to investigate what types of funds you have available as well as the expense ratios associated with them. Also, be sure to review the administrative fees associated with your employer’s plan. A mere 1% in fees can take a huge chunk out of your retirement savings.

Now, are fees reason enough to stop contributing? No, but if you have multiple options, it’s good to investigate each one. Not all of us are going to have $15,500 to contribute, or even $5,500, so you’ll want to make sure you get the most bang for your buck.

Ultimately, she participated because the tax benefits were significant enough and because her employer offered a nice selection of funds. Despite not having an employer match, the tax-deferred status of earnings and the amount she could contribute was simply too good to give up.

Plus, nothing says you can’t ask your employer to start offering a 401K match!

Catching up is hard to do, unless you’re talking retirement savings and you have the power of the US Government behind you. The contribution limits for various retirement accounts are increased if you are over the age of 50 and you can use them to your advantage if you didn’t contribute as much in your younger days. Below is a table listing the contribution limits for each account as well as the catch-up amount for the 2008 tax year.

So, if you’ve considered increasing your contributions to either account, know that you have a little extra breathing room if you want to contribute more and “catch up.”

If your company doesn’t match 401(k) contributions, email them. Email them, write a letter, collect signatures for a petition, do whatever you want but contact them and let them know that it’s important to you and other people in your company for the match to be offered. This is especially true if you don’t have a defined benefit plan, like a pension, because then your company isn’t contributing at all towards your retirement.

Now, you might say that writing letters and collecting signatures isn’t going to work or that your company cannot afford it. To the first concern, I say that unless you tell them, they won’t know. Maybe your company hasn’t tried it because they don’t think it’s important to the employees. If you’re a startup and there are only 50 people, it’s not worth it if only 10 people contribute. However, if you get all 50 to sign up, at least the benefits department is now aware that a demand exists. That leads to concern number two, whether it’s affordable. I don’t know the answer to that and chances are you don’t know either. Let them decide, you just have to let them know you’re interested.

So, if your company doesn’t have a match, have them explain why.

If you just opened your 401(k) or are investigating where you should be invested, my advice to you is to keep things as simple as possible. If it’s your first 401(k), or your first time looking at it with this company, it can be a little overwhelming to figure out what you should be doing. If it’s not your first 401(k), you might be worried that your investments aren’t adequately diversified versus your other investments or that you simply haven’t picked the best ones for your financial situation. Regardless of your motivation to analyze your 401(k) fund offerings, the task is still the same and can seem monumental… so let’s keep things simple.

The two things you need to figure out are cost and performance. There are a lot of options, more if your company uses a traditional brokerage to manage the 401(k) because it opens up the full range of Wall Street’s products, but sticking with mutual funds can’t be wrong. Forget active versus passive or ETFs or individual stocks, stick with mutual funds, if you want a low maintenance 401(k), and you’ll be saner for it.

So, with cost you’ll want to see whether you’re getting a good bang for your buck. Passive funds generally have low expense ratios and likely low sales expenses (active funds usually have much higher because there is more activity) and trend with the market. If you’re happy with that, as many are, an index fund is always a good option. If you want the potential for greater gains, you can look at an actively managed fund. Past performance isn’t an indicator of future performance, but what else are you going to base your decision on if not the past?

Lastly, remember to use tools to see if your diversification is in line. Are you in too much stock? Not enough bonds? Too much international and not enough domestic? Or you could just go with a target retirement or life-cycle mutual fund, they can take care of those details for you (if you trust them!).

I’ve left two jobs in the last five years and each time I rolled over my 401(k) into a Rollover IRA held at Vanguard. In both cases, I rolled over the IRA within a few months of departing my job and I did so for a small handful of reasons.

The number one reason for rolling over my 401(k) into a Vanguard Rollover IRA was simplicity. Why deal with yet another account accessed through yet another website, when I could integrate everything and deal with that account through a great brokerage such as Vanguard? I don’t need more fund balance mailings and fund performance reports, I need my life to be simpler so I can focus on the other things that matter. The end result was that I rolled both of my 401(k)’s into a single Vanguard account (and then I turned on electronic delivery of statements!).

The second reason was for diversification, which is related to simplicity. If I have to access two 401(k)’s in two accounts, it’s much harder for me to control the asset diversification because I couldn’t feasibly see two accounts at once and tweak them concurrently to get the right diversification. One of the 401(k) had some home-brew funds (not created by a major brokerage like Vanguard or Fidelity), so I couldn’t even be certain what the asset allocation within the fund itself was like. It was far easier to pull them all into Vanguard and break them up into Vanguard funds, though any major brokerage like T. Rowe or Fidelity would’ve sufficed as well (I chose Vanguard because I’ve had a long history with them and never been disappointed).

The third reason was cost. At Vanguard, I pay no account maintenance fees whatsoever. If you turn on electronic delivery, the administrative costs go down to $0 and are integrated into the expense ratios of each fund. The funds at Vanguard are much cheaper than the ones at either of my 401(k) plans, though some were pegged to the same benchmarks. Cheaper isn’t necessarily better, much like expensive isn’t necessarily better, but Vanguard has a solid performance record and cost is something I can control.

One account instead of three, an accurate picture of diversification, and controlling the one aspect of mutual fund investing I can control (cost), were the reasons I rolled over my 401(k)’s to a Rollover IRA.

For 2008, the Highly Compensated Employee income level was increased from $100,000 to $105,000. If your income is above $105,000 then you are considered “highly compensated” for the purposes of retirement plans. If you are curious as to the rules regarding HCE’s, please read this page that discusses what a highly compensated employee means.

I’ve rolled over two 401(k)’s into a Rollover IRA at Vanguard and both times the process was absolutely painless. If you’re thinking about taking advantage of Vanguard’s low fee index funds, and other mutual funds, then I think that rolling over a 401(k) is a great way to do it. The process is pretty easy and similar to rolling over to anywhere else.

First, you’ll need to open an account at Vanguard.com, specifically you’ll want this page because it focuses on moving money to Vanguard. If you run into any trouble, you can always call up their retirement specialists at 800-414-1742 and get to a human being in a few minutes. After you follow those instructions, you’ll need to contact your current 401(k) custodian (brokerage firm) to let them know you intend to perform a trustee-to-trustee rollover.

The name you want the check made out to is Vanguard FTC and then have the check mailed either to you, where you will forward it to Vanguard, or directly to Vanguard. The information that is provided to you from Vanguard’s online form should tell you where everything should be sent.

If you already have a Rollover IRA at Vanguard, simply do everything as you did before and include a letter that instructs them on how to divide up the funds. The letter is simple, just write that you want a certain dollar amount or percentage in which funds and you’re all done.

As easy as it should always be. (I don’t know if any other brokerage is easier or harder, I just know that Vanguard’s never been a problem)

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The 150th Carnival of Personal Finance is up!

Snowflaking is a play on words off Dave Ramsey’s Snowball psychologically-driven debt busting technique and it refers to putting small amounts towards your debt, snowflakes, to help eradicate debt. One of the ideas of snowflaking is that you can find small alternative sources of income and then push it towards your debt but you could really put it towards anything. You’re snowflaking when you drop your loose change in the piggy bank, so why not apply this towards retirement?

Snowflaking won’t work for things like a 401(k) since it will be a payroll deduction, but you could use it to fund your IRA, Roth or Traditional. I recommend using the piggy bank approach, putting small amounts of money into your piggy bank and then making one deposit each month, hopefully in addition to your monthly Roth IRA contribution. If you’ve maxed out your retirement fund, that’s wonderful and you can skip this. If you don’t max out your contributions to your Roth IRA each year, consider using snowflaking to help get you even closer. Remember, the 2008 Roth IRA contribution limit is $5,000 if you’re under 50 and $6,000 if you’re over (it’s the catch-up provision).