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How to Make the Best of a Bad 401(k)

NEW BERLIN, Ill. ( TheStreet) -- Chances are, you have a 401(k) or some other sort of Qualified Retirement Plan such as a 403(b), 457 or some other numerical combination. And chances are, unless you're in the extreme minority, your 401(k) plan has some features that are lacking. Most often, we'll see such things as limited options for diversification (although this is less likely these days), expensive fund choices and limitations for access to funds (not necessarily a bad thing).

How do you make the best of a bad 401(k)?

Unless you're in the extreme minority, your 401(k) plan has some features that are lacking, and you'll have to go through the funds to see where the weaknesses lie.

Review your fund options carefully. You should have the basics available to you in terms of diversification choices: domestic stock, international stock, money market (often referred to as stable return or something similar) and fixed income or bonds. If you don't have at least these basic allocation options available to you, you need to have a serious talk with your administrator.

Determine what your allocation plan should be. Chances are, you don't need all of the funds in the list. Often the list of options is much more than is necessary to get appropriate diversification in your investments. The basic options I mentioned earlier should be enough to cover the bases -- domestic stock, international stock and bonds. As your assets increase you may want to diversify further, such as by splitting your international stock into emerging markets and developed markets, but that's a topic for more advanced portfolio design.

The key is to determine what your allocation needs are and match them to the fund choices in your plan. Studies of portfolio construction have shown that 90% of success in investing comes when you have the appropriate categories represented, and the remainder is based on the actual investment choices used, expenses, timing, and taxes, among other things.

Look at the internal expense ratios for the funds. If your fund choices have expense ratios of 1% or more, these are some expensive fund options. Look at it this way: If the benchmark for your allocation category has a 7% return for the year and the fund you're using has a 1.5% expense ratio, just doing as good as the index will leave you with a 5.5% overall return once the expenses are removed.

If you truly don't have lower expense options to choose for a particular allocation category, all is not lost. As I mentioned, it's actually much more important to have the diversification, even with the drag of excess expenses, than to not use a particular category in your diversification.

Consider your investment options outside the plan. You should also diversify with regard to tax treatment of your investments. In addition to the 401(k) plan, you should have a Roth IRA and possibly even a taxable investment account. When you set up these accounts and contribute to them regularly, you can make it so you have much better choices to take the place of some of the more expensive options in the 401(k).

In addition to providing yourself with better investment options, these accounts can give you additional access to funds that could be limited in your 401(k). An example would be the ability to access Roth IRA contributions without tax impact.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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