401(k) plans have been around since the 1980s and have become the most widely used tool investors use to save for retirement. Investors who contribute to a 401(k) (or the similar 403(b) and 457(b) plans for nonprofits and governmental employees) are offered tax advantages, and oftentimes, employers match a percentage of what the employee contributes to the plan.
It’s encouraging to see how many people have access to these plans, but it’s frustrating to see how misunderstood, mismanaged, and misused they are. Some plans are great and others aren’t. In order to get the most out of your 401(k) plan, we must first clear up the most misunderstood aspects of 401(k)s, and then we’ll look at a framework that will help you know exactly what to do with your plan.
What You Need To Know
One of the best attributes of 401(k) plans is how passive they are for investors. After initially signing up for the plan, the only maintenance required is electing which fund or funds to use, deciding how much money to contribute, evaluating how well your funds are performing each year, and rebalancing your portfolio as necessary. It’s easy and requires almost no time. The only problem with this passiveness is the fact that it leads to a lot of misunderstanding and subpar investment results.
Here’s what you need to know to avoid the the most misunderstood aspects of 401(k) plans, so you don’t fall victim to subpar 401(k) performance.
401(k) Plans Aren’t Free
Just because we don’t have to cut a check to pay for our 401(k) doesn’t mean it’s free. 67% of those enrolled in a 401(k) plan think there aren’t any fees, but that’s far from the truth.
In Robert Hiltonsmith’s report The Retirement Savings Drain: The Hidden & Excessive Costs of 401(k)s, he calculated that over a lifetime, 33% of our investment returns our eaten in fees, and it’s you and me that pay; not our employer; not the government; not the broker signing us up; it’s us!
Since we don’t see withdrawals from our bank account or fee deductions on our pay stubs, most of us think our 401(k) is free. Fund companies and brokers exploit our misunderstanding, and we pay big for it.
Investment Options Are Limited
If you’ve ever signed up for a 401(k) plan then you’ve probably witnessed the limited selection of funds available for you to purchase. There’s a good reason. According to Watson Towers, a worldwide consulting firm, about 90% of 401(k) plans require pay-to-play fees in exchange for placing a mutual fund on a plan’s list of available options for employees to choose from.
These fees guarantee us a limited selection of funds while maximizing profits for brokers, mutual fund companies, and managers. These fees act as a tool that enable large fund companies to monopolize entire 401(k) plans and reap the benefits of a targeted monopoly. But the worst part is that these fees don’t stay with the fund company; they get passed down to you and me and dig into our investment returns.
Pay-to-play fees and other fund expenses can completely destroy the value of a 401(k) and can make it better to save for retirement by purchasing investments outside of your company’s sponsored plan.
The investment options we see are not always necessarily the options that are best for us. Rather, they are oftentimes the funds that are going to make the biggest pockets for the brokers signing us up.
Our Current Savings Rate Within 401(k) Plans Is Insufficient
Most of us rely on our 401(k)s as our sole investment vehicle to get us to retirement. This may be a bad idea, especially if your contribution is small. The average person that contributes to a 401(k) only contributes 3.1% of their income.
If you made $70,000 for 30 years, generated a 7% return after fees every year, and contributed 3.1% of your income to your 401(k) then you would only amass just over $200,000 by the end of the thirtieth year. In 30 years from now, $200,000 won’t give you much of a retirement, especially since you’ll only be able to keep 70-85% after Uncle Sam takes his cut.
If you’re only contributing 3% of your income to your 401(k), then hopefully you’re saving more significantly in other investment vehicles such as real estate, IRAs or an HSA.
401(k) Plans Are Not the Only Tax Advantaged Retirement Vehicle
This is one of the biggest misunderstandings surrounding 401(k)s. Many people have no idea how to save for retirement outside of using their employer’s 401(k) plan, and if they know it’s a possibility, they are scared to do so because of the tax advantages 401(k)s offer. But contrary to popular belief, there are other retirement investments that offer similar and oftentimes better tax treatments than can be found in some company sponsored plans.
Take Individual Retirement Accounts (IRA), Health Savings Accounts (HSA), and real estate for example. Each of which will be discussed in further detail below.
Maximize the Benefit of Your 401(k)
There are so many different 401(k) plans that it is impossible to give a solution that unanimously fixes all the problems for all of the 401(k) contributors out there. Determining whether or not you should contribute to your 401(k), how much you should contribute, and what investment option to choose depends entirely on your situation and your plan.
The four-step framework below will you know what strategy to apply to make the most of your 401(k) plan.
Step 1: Decide Where Your 401(k) Plan Is On the 401(k) Continuum
Here are the five most important factors to consider in determining where your plan fits on the 401(k) continuum:
1. Understand the fees
As we discussed above, 401(k) plans aren’t free, and in order to maximize our net returns, we need to do all we can to minimize our fees. Fees vary wildly from plan to plan, so you’ll want to reach out to your plan administrator and find out the expense ratio of each fund you’re investing in.
The expensive ratio is the “price tag” of the investment and only accounts for a portion of the total cost, but it’s the best way to get a good idea of how expensive a fund is. The lower the expense ratio the better. Anything with an expense ratio 0.45% or more, falls on the weaker side of the continuum for this category. Anything with an expense ratio less than 0.2% falls on the stronger side and anything between 0.2% and 0.45% lands somewhere in the middle.
2. Understand the investment options
There are normally several different fund options to consider when contributing to your 401(k). Most options will likely be high-cost mutual funds tagged as high-growth funds. If you’re lucky, you’ll have the option to invest in low-cost index funds through your 401(k). Another option may be target date funds, which are a good option as long as the investments within the target date fund are index funds rather than actively managed mutual funds.
Beyond that, you may get to decide between a Roth or traditional plan. Similar to an IRA, with the Roth, you pay taxes on the money you contribute up front, but all the compound growth is tax free. With the traditional, you don’t pay taxes on the money you contribute today, but you’ll have to pay taxes on it and all the compound growth later when you withdraw the funds. Generally, if you think you’ll be in a lower tax bracket when you retire, then a traditional plan may be better.
Low-cost index funds under a Roth or traditional plan are generally the ideal options and will land on the stronger end of the continuum. If your plan only offers mutual funds or annuities, then it will land on the weaker side of the spectrum.
3. Know the employer match
If your employer offers a 401(k), then they may be willing to match a certain percent of what you contribute up to a threshold of your total income. For example, your employer may be willing to give you 50 cents for every dollar you contribute up to 5% of your salary. So in order to maximize your employer’s contribution, you would contribute 5% of your pay into your 401(k) and your employer would contribute half of what you did—an automatic 50% return—not too bad. The higher the dollar match and higher the income threshold, the better the plan is for you. Here’s how I categorize employer matches:
– If your employer only matches 10% of your contribution or less, then it’s a weak match.
– If your employer matches 11-20% of your contribution, then it’s between weak and average.
– If your employer matches 21-30% of your contribution, then it’s average
– If your employer matches 31-40% of your contribution, then it’s above average
– If your employer matches 41% or more of your contribution, then it’s a strong match.
4. Know the employer contribution schedule
The timing of when employers actually contribute to your 401(k) can cause a big difference on compound growth and how strong your plan is. Some employers contribute to the plan every pay period, some every month, some quarterly, and others only once a year. The more often your employer contributes throughout the year, the better, since it gives your money more time to compound and grow.
5. Know the vesting period.
How long you have to work for your employer before their contributed money vests (actually becomes yours) is another important factor to consider. Sometimes their contributions vest immediately while other plans don’t vest for years. The shorter the vesting period the better. Immediate vesting falls on the strong side of the continuum while a 5 year vesting period is on the weaker end.
Here’s a simple depiction so you can visualize the 401(k) continuum:
Now in order to decide where your plan fits on the continuum, you’ll have to weigh all of the 5 factors together. Depending on what you value most, you may prioritize these 5 points differently than me, but here’s how I order them and why:
1. Employer Match. This is generally the most important to me since it’s about as close as you can get to free money. If the employer offers a very strong match (dollar for dollar up to 5% of income or more) then it’s very likely that I’ll put the plan on the stronger side regardless of the other factors. On the other hand, if there is no match, then I’m likely to categorize it as a weaker plan unless it has very low fees and strong investment options.
2. Options. The investment options available is the other most important criterion since they will generally dictate how expensive your plan is, how strong your returns can be, and how well diversified your portfolio could be.
3. Fees. No matter how small the fees appear to be, like interest, they compound and with time, can have a huge impact on your future savings.
4. Vesting Period. Short vesting periods are important because I value my freedom and flexibility. Long vesting periods can obligate us to stay at a place where we don’t find the work fulfilling.
5. Contribution Schedule. I like my money to work as hard as possible for me, and when my employer contributes to the plan more frequently, my money has longer to work and grow.
Step 2: Know How Your Alternative Investment Options, Savings Goal, and Income Impact Your 401 (k) Strategy
It’s impossible to determine your best 401(k) strategy by solely looking at the terms of your plan. You cannot analyze it in a vacuum. You must consider other retirement investment vehicles available to you, your annual retirement savings goal, and how your income impacts your strategy.
Know What Your Other Investment Options Are Outside Of Your 401(k) Plan
In order to apply the right strategy to your 401(k), you must look at all of your available retirement saving alternatives. Here are some of my favorite:
– Health Savings Account (HSA). If you qualify and have a high-deductible health insurance plan, you may want to contribute to an HSA. Here’s the advantage of these: Contributions are tax deductible; interest earned is tax free; account owners may make tax-free withdrawals for qualified medical expenses; there is no year-to-year maximum account carryovers like flexible spending accounts; and there aren’t income limitations. In other words, if the money you contribute to an HSA is used for qualified medical expenses, you’ll never have to pay taxes on it–not even the investment growth.
– Individual Retirement Account (IRA). There are primarily two types of IRAs—a traditional IRA and a Roth IRA. With a traditional account, you are generally allowed to defer paying taxes on the money you contribute today (the deduction is phased out after you pass a particular income threshold), but you’ll have to pay taxes on it and all the growth when you withdraw the funds. A traditional IRA is one way to reduce your tax liability now while you save for retirement.
On the other hand, with a Roth IRA, you pay taxes on the money you contribute today, but you don’t have to pay taxes on all the interest you accrue over the life of the investment. Due to certain income limitations, not everyone is able to contribute to a Roth, but if you are, it can help enable you to accumulate tax-free wealth.
Find more details about setting up your own IRA here: How To Set Up Your Own IRA: 6 Simple Steps To Start Saving For Your Retirement Today.
– Real Estate. Real estate is one of my favorite asset classes as it offers benefits that most other assets don’t. I’ve written an entire post about it: The Top 5 Reasons Why I Invest In Real Estate.
Essentially, real estate can generate income now, diversify your asset base and your income, create tax advantages, capture equity, and appreciate over time. If used correctly, it can help generate massive wealth.
– Build A Sellable Business. Another investment option to consider is a business you can build now and sell when you’re ready to retire. I’ve known many dentists, CPAs, veterinarians, electricians and other professionals that use their business as their primary retirement asset. Entrepreneurship is far from easy, but it can be extremely rewarding.
With that said, you’ll never want to use your business as your sole source of retirement savings. If the business fails, so will your retirement. Your business should be a portion of your overall retirement nest egg, not the whole thing. Diversification is imperative to reducing risk.
– Taxable Brokerage Account. You can also buy securities (stocks, bonds, etc.) in a taxable brokerage account; however, you will not get the same tax advantages you get with an IRA, HSA, or your 401(k). Therefore, I generally recommend using this option after you’ve already maxed out your contributions with the other investment vehicles (IRA, HSA, 401k) available to you, or if you’ve decided you don’t want to invest in real estate directly.
The retirement investment options outside of your 401(k) won’t directly impact where your 401(k) plan lands on the 401(k) Continuum, but they will impact the funding strategy that’s best for you. If you have strong alternative options and a weak 401(k), then you’ll probably be better off funding and maxing out your alternatives before allocating money towards your 401(k). If you have weak alternatives and a strong plan, then your 401(k) should generally be your first priority.
Know How Much You Will Contribute To Retirement As A Whole
The amount of money you’re planning on contributing to retirement will impact the strategy that’s best for you. Here’s why: there is a maximum you can contribute to IRAs, HSAs, and 401(k)s.
For 2017, with both Roth and Traditional IRAs, you and your spouse can each contribute a maximum of $5,500 ($6,500 if you’re over 50) per year. With HSAs, for self-only coverage, you can contribute up to $3,400. For family coverage, you can contribute up to $6,750. The max you can contribute to your 401(k) is $18,000.
So here’s how your desired retirement savings impacts your 401(k) strategy. Let’s say you’re single, you want to save $30,000 for retirement in 2017, you have a strong 401(k) plan with good investment options, you’re eligible for an HSA, and you don’t have any limitations on your IRA. If your 401(k) plan is strong with good investment options, then it has the highest priority. As such, your first $18,000 will generally go there. Then you’ll max out your HSA with $3,400 and your IRA with $5,500, leaving with you $3,100 to invest. The $3,100 would need to be invested in real estate, your business, a taxable brokerage account, or some other asset class since you already maxed out your tax advantaged options.
Please note that if you’re interested in real estate, have your own sellable business, or other potential investments, then you may be better off revising the priority of your investing to match your goals and circumstances.
Know How Your Income Will Impact Your Retirement Savings
As alluded to earlier, there are certain income limitations that restrict the benefits of IRAs. If your income exceeds a certain threshold relative to your tax filing status, then you won’t be eligible to contribute to a Roth IRA. In addition, if your income is too high, then you may not receive the tax deductions with a Traditional IRA.
On the other hand, the benefits of a 401(k) are generally not restricted or diminished as your income goes up. 401(k)s generally offer better incentives than IRAs for high income earners (excluding the other considerations we’ve discussed above).
Check out this article for more details on income limitations with IRAs: How To Set Up Your Own IRA: 6 Simple Steps To Start Saving For Your Retirement Today.
As such, even if your plan falls on the weaker end of the spectrum, in order to hit your saving goal, you may want to allocate money into your 401(k).
Step 3: Decide If and How Much To Contribute to Your 401(k)
After you have decided where your plan sits on the 401(k) continuum, you’ve considered your alternative options, looked at your savings goal, and thought about how your income impacts your strategy, it’s now time to decide how much you should contribute.
If your plan ends up somewhere on the weaker side of the spectrum, then generally you should forgo contributing to our 401(k) plan, and invest in the market using an HSA or IRA. I recommend buying low-cost index funds, and contributing the max allowed for any given year. Click here to learn how to best invest in the market and buy index funds.
The exception to this rule is if you have additional money to save fore retirement and you’ve already maxed out your IRA and HSA contributions and are against investing in other retirement vehicles such as real estate. If that’s the case, then stashing extra savings into your 401(k), even if it’s on the lower end of the spectrum, is still a good idea.
If your plan falls on the stronger side, then you should contribute at least enough money to get the maximum employer contribution. So if your employer will match up to 6 percent of our salary, then contribute 6 percent of your salary into your 401(k). You should do this even if the employer only contributes 20 cents on the dollar once a year. As long as your plan is on the strong side of the spectrum, then suck the max contribution out of the plan.
After that, you’ll generally be better off if you take advantage of an HSA (if you qualify), since, if used correctly, you can avoid paying taxes entirely.
Next, you’ll look if you have any restrictions (deduction phase out or ineligibility) on the benefits of your IRA. If you do, then most likely you’ll want to put additional money into your 401(k) before your IRA.
If the benefits of your IRA are not limited because of your income, then you’ll want to focus on the investment options available. If you don’t have better low-cost index funds in your 401(k) than you could in an IRA, then you’d focus on your IRA first. If you do have great funds in your 401(k), then prioritize it ahead of your IRA.
Here’s the general order I recommend for making the most of your retirement savings.
- Max out employer contribution.
- Max out an HSA if you qualify.
- Max out IRA unless the benefits are limited due your income. If they are, max out your 401(k)
- Max out 401(k) or IRA, whichever you didn’t max out in step 3.
- Use alternative investment vehicles (taxable brokerage account, real estate, etc.)
As mentioned above, this priority may change depending on your eligibility, your savings goals, and how strong your alternative investment options are. For example, if you like real estate and you understand it, then you may want to invest in real estate after maxing out your employer match, but before maxing out your total 401(k) contribution with the $18,000 limit.
Strong 401(k) plans give you a lot more flexibility on how to best tackle saving for retirement.
Plans in the Middle
If your plan ends up somewhere in the middle of the spectrum then you’ll want to look at what I call the two primary questions: 1) Does it include low-cost index funds, and 2) How strong is the employer match?
If both of these factors are on the weak side of the spectrum, then you’re most likely better off prioritizing HSAs and IRAs above your 401(k) (barring all other considerations—income, savings goals, alternative options, etc.).
After you’ve maxed out your HSA and IRA with index funds, then you’ll want to go back and invest your additional retirement money into your company’s 401(k) plan.
If both of the factors above are on the stronger end of the spectrum, contribute as much as money as needed to get the maximum contribution from your employer, and then apply the same strategy you would if your plan was on the stronger end of the 401(k) continuum.
If the two primary factors are on opposing sides of the spectrum, I generally recommend contributing as much as necessary to get the maximum employer contribution, and then using an HSA or IRA, before completely funding the 401(k).
Here’s why: Using a 401(k) plan to save retirement enables us to tap into some of the most powerful principles of personal finance—systems and automation. Generally, once a year we make an election of how much we contribute, and the system makes our retirement savings grow automatically. It’s the automated financial plan and there is no real additional work needed on our end.
Step 3: Select the Right Investment Option
Now that you know how much to contribute to your 401(k) plan, the only step left is deciding which investment option to use.
Roth vs Traditional
As we discussed above, with a roth 401(k) you have to pay taxes on the money you contribute today, but all your compound investment growth is tax free. With a traditional 401(k) you get a tax break today, but have to pay taxes on all the money you withdraw later.
The answer of which type of plan is better depends on your situation. If you’re in a low tax bracket now, you may be better off using a Roth. If you’re in a high tax bracket now and expect to be in a lower tax bracket at retirement, then you’ll be better off with a traditional. If you have the ability to max out both an IRA and a 401(k), then you may be better using Roths since you’re essentially contributing more dollars (post tax dollars vs pretax dollars). If you’re wanting to reduce your current taxable income, then a traditional may be better. Either way, pick what option works best for you. In the end, it may not matter much. What matters a heck of a lot more is making sizable contributions to your future.
Which Fund is Best
There are three fundamental questions to ask in order to select the best fund or funds for your 401(k).
1. What is the expense ratio? Make sure to select a fund with low fees. It will have a huge impact on your net return over time. If index funds are an option, they are most likely going to have the lowest costs.
2. How has the fund performed? You’ll want to make sure you select a fund that has a strong performing track record. Look up and compare each fund on Yahoo! Finance to determine how well the different funds have performed over various time periods.
3. How much diversification is the fund giving you? Diversification is essential as it minimizes your risk. Most likely, you’ll have to select multiple funds to achieve the appropriate amount of diversification. Generally the more diversification, the better, but you must weigh it with the other two questions above.
You want to select funds from different asset classes(stocks, bonds, etc.). For stocks, you’ll want a blend of large cap (bigger companies), small cap (smaller companies), growth, value, domestic, international, and potentially emerging market equities for your portfolio. For bonds, if it’s available, a total bond market index fund or something similar would be great.
If possible, a great option for a lot of people is to select a target date fund so long as it is built off of indexes and has low fees. Indexed target date funds generally have low fees and they automatically allocate more of your assets to more conservative investments as you move nearer to retirement. The actively managed target date funds are normally too expensive to be a priority for me.
If an indexed target date fund is not an option, or you’re more confident in building your own portfolio, then I recommend using the 3 questions above to figure out which funds will best meet your objectives. I generally recommend allocation a portion of your funds to domestic equities, international equities, and bonds. The percentage you choose to allocate to each asset class depends on your risk tolerance and time horizon, but a general rule of thumb is to subtract your age from 110 and put that percentage in stocks and the rest in bonds.
If you can only choose one fund, then I’d choose a indexed target date fund. If that’s not an option, I’d use domestic equities that provide broad exposure such as a total stock market index.
Not all 401(k) plans are created equal—some should be used after other investment options are maxed out and others should have your top priority. By avoiding the misunderstanding that surrounds 401(k)s and using this framework, you can maximize the benefit of your 401(k).
Use the framework to evaluate your 401(k) and take the necessary action to make your plan as beneficial as possible. Contribute the appropriate amount to your 401(k) and select the best funds.
In addition, make sure you’re saving at least 10% of your income for retirement. If required, open an IRA or HSA and save the amount necessary to get you to a fulfilling future. See this article for more information on opening up additional investment accounts: The Best Way To Invest In the Market.
Check out this article to find out more details about setting up your own IRA: How To Set Up Your Own IRA: 6 Simple Steps To Start Saving For Your Retirement Today.
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