How Your Company’s 401(k) Might Be Ripping You Off
Your 401(k) is one of the best tools you have to prepare for retirement, but this employer-sponsored retirement account might be ripping you off at the same time it’s helping you grow your money. If you have a 401(k), it is imperative to understand how you are charged, what you pay, and how to save on fees in the future.
The Benefits of a 401(k)
First, it’s worth noting that a 401(k) carries a lot of benefits for workers, namely:
- Pre-tax contributions
- Employer matching
- Automated investing
“Pre-tax contributions” mean that the dollars you put into your 401(k) account are not taxed before they go in. Instead, you can contribute tax-free, watch your investments grow over the course of your career, and only have to pay taxes when you withdraw during retirement. You may have a lower income by then, and therefore a lower tax rate, in retirement.
Employer matching is another great benefit. While not required by law, many employers choose to match your contributions up to a certain percentage of your annual pay. In my past, I received employer matching of around 3 percent to 4 percent of my gross pay, though matching up to 6 percent is not unheard of.
Finally, because your contributions are deducted from your paycheck, your 401(k) savings are completely automated. This may be the biggest benefit of all, as it ensures you will actually save and invest for retirement.
Two Layers of 401(k) Fees
With all that said, the main drawback is the fees you’ll have to pay.
Your 401(k) account is most likely managed by a large investment management company or bank like Wells Fargo, Fidelity, or Vanguard. These companies do not offer 401(k) management out of the goodness of their hearts — they do it to earn a profit. This may be a flat fee, or based on a percentage of your account value. For example, you may pay 0.5 percent, 1 percent, or 2 percent annually, which is automatically deducted from your account so you hardly notice. Unless you read your statement, you could be like the 71 percent of those polled by AARP who didn’t think they were charged a fee at all.
Next, you are charged fees by the specific mutual funds you choose for your 401(k) account. If you have access to low-fee funds from providers like Vanguard, you may pay very low fees, as small as .04 percent. On the higher side, however, you may find funds that charge in excess of 2 percent. While a 1.95 percent difference may not feel like much, the difference is $1,950 per year on a $100,000 account. Over several years, that could cost you tens if not hundreds of thousands of dollars in investment gains.
Between the two, you are hit with a double whammy of fees. According to a 2015 study by Morningstar, the average expense ratio across all funds was .64 percent; while the 401(k) management fees that most plans charge will tack on an additional 1 percent fee, according to The Motley Fool.
Cutting 401(k) Fees at Your Current Job
While you can’t get out of paying management fees, you do have some options when choosing your investments, which can improve your fee picture.
Every fee charged by mutual funds is public, and you can typically find that information quickly in your 401(k) information packet or employee intranet. Passively managed funds including index funds and target retirement date funds generally charge less than actively managed funds.
Also, don’t discount the idea of your HR department making changes to your 401(k) to save you money. If you find your management fees are higher than the industry average, find the right person to talk to at your company about moving to a lower cost plan. Startups like ForUsAll are disrupting the industry by offering plans for small businesses with low fees, and large enterprises can migrate to providers like Vanguard, Fidelity, or Charles Schwab to access more and lower-cost investment options.
Don’t Forget to Roll Over Your IRA When You Leave
Your 401(k) account has limited investment options, which were picked by your employer and 401(k) manager. Odds are those limited options include mostly high-fee funds, and don’t necessarily include the best investment choices for your needs.
To escape the fees and get access to more options, you can roll over your 401(k) to a Rollover IRA account when you switch employers. You can get help from your rollover IRA brokerage to call your old 401(k) provider and make sure it transfers without any problems.
Rollover IRA accounts are generally free of management fees, and you can choose from any publically traded stock, bond, or fund instead of just a short list. This transition is hugely valuable on accounts with large balances, as it means you can find funds with smaller expense ratios. This means that you’re cutting out one fee altogether, and potentially reducing the fund fees you were paying.