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 are essentially worthless. 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 to use, deciding how much money to contribute, and evaluating how well your fund is performing each year. 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 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.
401(k) Plans Are Insufficient
Most of us rely on our 401(k)s as our sole investment vehicle to get us to retirement. This is a bad idea as 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.
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 the same and oftentimes better tax treatments than can be found in some company sponsored plans.
Take Individual Retirement Accounts (IRA) for example. There are two types of IRAs—a traditional IRA and a Roth IRA. With a traditional account, you are allowed to defer paying taxes on the money you contribute. A traditional IRA is one way to reduce your tax liability now. 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. A Roth IRA enables you to accumulate tax-free wealth.
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 three-step framework below will enable you to maximize the benefit 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 the 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 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. Using a Roth is generally a better idea unless you plan on being in a smaller tax bracket when you retire or if you’re trying to reduce your current tax liability.
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. This is the most important factor in determining whether your 401(k) plan is good or not. 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 of 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 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 are the next most important since they will generally dictate how expensive your plan is, how strong your returns can be, and how well diversified your portfolio is.
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: Decide If and How Much To Contribute to Your 401(k)
Now that you have decided where your plan sits on the 401(k) continuum, it’s time to decide how much you should contribute.
If your plan ends up somewhere on the weaker side of the spectrum, then you should forgo contributing to our 401(k) plan, and invest in the market using an IRA. I recommend buying low-cost index funds in a Roth IRA, and contributing the max allowed for any given year ($5,500 per individual in 2016 depending on age and income). Click here to learn how to best invest in the market and buy index funds.
The only exception to this rule is if you have already maxed out your IRA contributions and are against investing in other retirement vehicles such as real estate. Maxing out your IRA contributions won’t be easy as each individual can invest $5,500 into both a roth and traditional IRA. In other words, a couple can contribute $11,000 to roth IRAs and $11,000 to traditional IRAs in the same year.
There is generally no reason to settle for and invest in a weak 401(k) plan that will suck your retirement savings.
If your plan falls on the stronger side, you should contribute enough money to get the maximum employer contribution, but generally, not a dollar more. Here’s how to do it. If the plan says that your employer will match up to 6 percent of our salary, then contribute 6 percent of your salary. 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 side of the spectrum, then suck the max contribution out of the plan no matter what.
Now if after maxing out the employer’s contribution to your plan only means you’re saving 5% of your income for retirement, then I recommend saving at least an additional 5% of your income for retirement outside of a 401(k). You can do this by opening up an IRA and buying low-cost index funds. Click here to learn the best way to do it.
If the investment options within your 401(k) plan are index funds, have an expense ratio lower than 0.16%, and are strong on all the other 401(k) factors, then you’re better off just putting your additional retirement funds into your company plan rather than opening up a separate IRA. That is unless you have more than $18,000 to invest towards retirement. $18,000 is the current max any individual can contribute to a 401(k) plan.
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 not using your company’s plan. Rather you should open up a roth IRA, buy low-cost index funds, and max out your IRA contribution. Only after you’ve maxed out your IRA contributions should you 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.
If the two primary factors are on opposing sides of the spectrum, I recommend contributing as much as necessary to get the maximum employer contribution but no more.
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, but for the majority of people the roth option offers more upside. I recommend taking advantage of the roth unless you are convinced that you’re going to be in a much lower tax bracket when you retire or if you are really needing to reduce your tax liability today. Under those circumstances, you may want to elect a traditional plan.
Which Fund is Best
There are three fundamental questions to ask in order to select the best fund 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? A well diversified fund is important as diversification is one of the best ways to reduce your risk of the inevitable ups and downs of stocks and bonds. The more companies and the more asset classes (i.e. stocks, bonds, REITs, etc.) included in the fund the better diversified it is. Generally the more diversification, the better, but you must weigh it with the other two questions above. Target date funds and an S&P 500 index fund offer strong diversification.
Overall, for 401(k)s I generally recommend using a target date fund as long as it is built off index funds rather than actively managed mutual funds. Indexed target date funds have low fees and they automatically allocate more of your assets to more conservative investments as you get older.
If a target date fund isn’t an option, my next choice would be a low cost index fund. Other than that, you’ll have to use the 3 questions above to determine which option is best for you.
Not all 401(k) plans are created equal—some shouldn’t be used at all and others provide a great tool to save for retirement. 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 fund.
In addition, make sure you’re saving at least 10% of your income for retirement. If required, open an IRA 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.
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