Will Your 401(k) Make or Break You?

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It was 1978, and Saturday Night Fever, the Commodores’ “Three Times a Lady,” and Charlie’s Angels were the nation’s biggest hits. But a new tax law that year would prove even more significant. The Revenue Act of 1978 introduced a provision that become Section 401(k) of the Internal Revenue Code. This bill, and the retirement accounts it helped create, have since become a mixed blessing.

On Jan. 1, 1980, 401(k) accounts became official. In the 30 years that followed, they’ve grown in popularity and usage, replacing defined-benefit pensions at many companies. In 1985, just 10 million Americans participated in them; today some 50 million do, entrusting more than $2 trillion to these plans.

But while 401(k)s can provide a comfortable retirement, they’re also far from perfect.

The problems with 401(k)s
For several reasons, 401(k) plans are failing to save many Americans’ retirements.

Many people just aren’t saving enough in them. The median sum in 401(k)s as of the end of 2008 totalled just $12,655, meaning that half of all workers have set aside even less in their accounts. For those with accounts open since 2003, the sum was a healthier $43,700 — but even that’s not much. Even if you’re 15 years from retirement, you add another $8,000 per year, and it all grows at 8%, you’ll end up with just $373,000.

Many people also fail to invest effectively in their accounts. Some leave most or all of their money in their employers’ stock, or in low-yielding bonds, or in other “safe” options. But if those investments don’t grow enough to provide for your retirement, they’re not safe at all.

Worst of all, 401(k)s represent a transfer of risk and responsibility for retirement income from employers (via pensions) to employees. Most employees are simply ill-equipped to make the most of them. They don’t know to follow Warren Buffett’s excellent advice: “Be fearful when others are greedy, and be greedy when others are fearful.”

The upside of 401(k)s
On the plus side, a growing trend among employers is to enroll new workers in 401(k)s by default, which boosts overall participation rates.

Also, “target-date” mutual funds are growing in popularity within 401(k) plans. Though they themselves are not perfect, they do take on the responsibility of shifting assets from stocks to bonds as the worker nears retirement. As an example, here’s a quick breakdown of holdings in the Vanguard Target Retirement 2025 (VTTVX) fund, for investors planning to retire that year:

Source: Morningstar.
*Return is for similar fund (VBMFX) with longer history.

There are other upsides to 401(k)s. They’re portable, which is handy, given the average American’s job duration of about five years. As long as workers don’t commit the big blunder of cashing out their accounts every time they switch jobs, they can keep growing their nest egg from job to job. (Or they can transfer their money to an IRA.)

They have generous contribution limits, too. In 2010, most of us can contribute as much as $16,500 to a 401(k) — and those 50 or older can throw in an extra “catch-up” $5,500, bringing their total to $22,000. (IRA contribution limits for 2010 are $5,000, plus a catch-up $1,000.) If you manage to sock away $15,000 per year for 20 years which grows at an annual average of 8%, you’ll accumulate more than $740,000. Chipping in more, earning a better return, or investing longer can increase that substantially.

A new possibility for 401(k)s presents a final reason to smile: In future years, you and your colleagues may be able to buy annuities through your 401(k)s, which will essentially let you create your own guaranteed income stream. In short, they’ll function as do-it-yourself pensions.

This article was originally published as Will Your 401(k) Make or Break You? on Fool.com