How Do 401ks Work?

[Baron von Schtinkenbutt]

Right now, in my hand, I hold a Raytheon chip.

What chip would that be?  We don't really manufacture semiconductors.

[Ed Anger]

Sun chip. green onion flavored.

[Grey Fox]

Right now, in my hand, I hold a Raytheon chip.

What chip would that be?  We don't really manufacture semiconductors.

It's an old chip, atleast 6-7 years old.

Raytheon 9846NJC 2376KCC

[DGuller]

I don't care for nanny state restrictions. We have limits on contribution percentages, which can be really annoying if you want to max out your 401k but don't want to contribute evenly throughout the year.

I differ with you on this one.  I think there should be many more nanny state restrictions, hopefully culminating in complete replacement of 401k as we know it.  I have a strong feeling that many years from now, we will wonder what the hell we were thinking making people with no financial education be in charge of huge investment decisions, after it turns out that most 401k contributors have burned a lot of their wealth on misjudgments.  The whole system is like a reversal of the centuries-old theory on specialization of labor. 

[dps]

You're a prince Fredo.  Couple more questions if you're in the mood.

A 401k employee is stuck with those 10 choices until they leave the company?  What happens then? 

Also, do IRA withdrawals get treated as regular income?  You're not on the hook for all accumulated capital gains are you?

It depends, the employer may let you stay in the 401k plan, in which case you are still limited, but you can roll the plan into an IRA, which is probably a better choice as there you can invest in whatever you want.

Also, if you go to work for another employer who offers a 401K plan, you can roll over into the new employer's plan.

[alfred russel]

I differ with you on this one.  I think there should be many more nanny state restrictions, hopefully culminating in complete replacement of 401k as we know it.  I have a strong feeling that many years from now, we will wonder what the hell we were thinking making people with no financial education be in charge of huge investment decisions, after it turns out that most 401k contributors have burned a lot of their wealth on misjudgments.  The whole system is like a reversal of the centuries-old theory on specialization of labor.

I agree, but we both work in finance and presumably know what we are doing. I'd rather roll without the training wheels.

[crazy canuck]

I agree, but we both work in finance and presumably know what we are doing.

The folks approving the sub prime mortgages probably said the same thing.

[alfred russel]

The folks approving the sub prime mortgages probably said the same thing.

True, but then I didn't approve sub prime mortgages, so I'm probably smarter than them.

[DGuller]

Personal investing is a weird thing.  Personally, I find that the more I know, the more I realize that I don't know much at all.  Often I find that most people who think they know how to invest are actually blissfully ignorant ("most" becomes "nearly all" during the boom times).  Investing is an incredibly complicated field, and experience by itself can actually teach you horribly wrong lessons.

[alfred russel]

Personal investing is a weird thing.  Personally, I find that the more I know, the more I realize that I don't know much at all.  Often I find that most people who think they know how to invest are actually blissfully ignorant ("most" becomes "nearly all" during the boom times).  Investing is an incredibly complicated field, and experience by itself can actually teach you horribly wrong lessons.

But my job is to invest.

In any event, the only "nanny state" restrictions I was complaining about were the contribution limits: I max out my 401k, and there have been times I didn't have a need for money early in the year and would have wanted to contribute all my take home pay to get that out of the way, or later in the year I wanted extra take home pay for a few paychecks but wouldn't be able to meet my contribution limit if I did so as I couldn't go over 25% on my last couple of paychecks. Is that really a high risk proposition?

[Admiral Yi]

Personal investing is a weird thing.  Personally, I find that the more I know, the more I realize that I don't know much at all.  Often I find that most people who think they know how to invest are actually blissfully ignorant ("most" becomes "nearly all" during the boom times).  Investing is an incredibly complicated field, and experience by itself can actually teach you horribly wrong lessons.

Can you provide one or two examples of the incredibly complicated nature of investing that most people don't understand?

[DGuller]

Can you provide one or two examples of the incredibly complicated nature of investing that most people don't understand?

The big thing is that people very often are unaware of the risks they're taking on, or cannot comprehend it.  They're exposing themselves to more market risk that they really can handle, and are also often not diversified properly.  It's not surprising, risk management is complicated even for people who are trained for it, and it's not easy to train a layman for it.

And, as I said earlier, the worst thing about investment mistakes is that reasonable people can make them, and actually learn the wrong lesson.  If you make the mistake above, and invest all your considerable 401k balance in one concentrated risky fund (like REIT), you may not get burned.  Instead you may actually reap winfall profit for some time, if variance goes your way.  You may then learn that the way to invest is to chase the big win by putting all your wealth on the line, because that's what worked for you in the past.

[Admiral Yi]

The big thing is that people very often are unaware of the risks they're taking on, or cannot comprehend it.  They're exposing themselves to more market risk that they really can handle, and are also often not diversified properly.  It's not surprising, risk management is complicated even for people who are trained for it, and it's not easy to train a layman for it.

And, as I said earlier, the worst thing about investment mistakes is that reasonable people can make them, and actually learn the wrong lesson.  If you make the mistake above, and invest all your considerable 401k balance in one concentrated risky fund (like REIT), you may not get burned.  Instead you may actually reap winfall profit for some time, if variance goes your way.  You may then learn that the way to invest is to chase the big win by putting all your wealth on the line, because that's what worked for you in the past.

You may be right, but I think our perception of everyday investor boneheadedness might be skewed by the tendency of the media to focus only on the poor blubbering schmucks that put everything into own-company stock and got wiped out.

It would be interesting to see some stats on the percentage of 401k money held in lower risk assets.

[The Minsky Moment]

Some 401k plans have a self-direction option.  Mine does for example.  You have to sign a bunch of forms but it is doable.

[alfred russel]

Can you provide one or two examples of the incredibly complicated nature of investing that most people don't understand?

Here are a few:

1) Taxes
2) The effect of fees on long term returns
3) Diversification & Risk Management
4) The money needed in future years
5) The fact that your most accessible financial advisors, such as those in a bank, are pushing crappy investments like life insurance and annuities, that do not offer straightforward fees or ways to measure investment return. Television advice is a disaster.
6) Insurance
7) Debt

I don't think that many of those are especially complex, but taken together financial planning can be tricky, and a single mistake in one area can possibly sink the boat. I don't think that there is a lot of knowledge about those topics in the general population.