What’s Wrong with Your 401(k)?

401(k) plans are always in the news.  And they should be.  This type of retirement plan – synonymous with all retirement plans – is one of the most widely used retirement savings vehicles in the U.S.  In the past several years, there has been significant focus on 401(k) plan fees, and whether plan sponsors (your employer) and vendors (investment, mutual fund, and insurance companies) are disclosing just what fees are being deducted directly from participant accounts.

That’s about to change.  The Department of Labor recently announced that beginning August 30, 2012, plan sponsors will be required to disclose the details of 401(k) fees paid by participants.  The annual disclosure will provide investment, administrative, reporting, record keeping, and other fees.  Beginning November 14, 2012, plan participants will receive quarterly statements that show the actual fees that were deducted from their accounts during the previous quarter (in this example, July – September).

This is a good thing, as it’s completely reasonable for participants to know just what fees they are paying – it’s only fair.  Greater fee disclosure may in fact lead to pricing competition, and encourage vendors to offer investment choices with lower underlying fees.  That’s a possible outcome, and what remains to be seen is how investment companies make up for lost revenue.

WHAT’S WRONG WITH YOUR 401(k)?

It’s probably underfunded. 

Fidelity Investments, which manages 11.6 million 401(k) participant accounts, reports that as of the end of 2011, the average participant balance was just under $70,000.  Now, averages don’t tell us everything, but what this one tells me is that among those millions of accounts, there are far too many with low balances.  What we can extrapolate from this number (given that it’s based on 11.6 million accounts) is that Americans are just not saving enough for retirement.

It may be suffering from lack of attention. 

When was the last time you reviewed the investments in your 401(k) account?  One year?  Two years?  Never?  How did you choose the funds into which your contributions are invested?  Are your contributions being invested, or simply going into a cash or money market account?

It is always good practice to review your account periodically – not only the mutual funds that your assets are in, but also the plan’s other fund offerings (there may be something better), as well as the asset allocation of your portfolio (the relative exposure to domestic and international stocks, bonds, and other asset classes).  If this is not something you feel interested in or comfortable with, then consider an age-based “target retirement date” fund, or hire a financial adviser to assist you with this exercise.

It may offer only limited investments.

It’s true:  some 401(k) offer lousy, bloated, expensive investment options.  But there aren’t any laws requiring your employer to offer only top-performing, lean, and cheap mutual funds.  Plus, evaluating funds involves some degree of subjectivity.  So, as you’ll read below, limited investment options should not be a reason to neglect saving for your future (especially if there is an employer match, if you’re in a high tax bracket, and if you have more than $5,000 per year to invest, which is the current annual IRA contribution limit).

Fund fees may be high (and fee disclosures may be murky at best). 

As I mentioned above, thanks to increased attention to the issue of high fees and fee disclosures that are cryptic at best, the new Department of Labor regulations should lead to fee disclosures that are (one would hope) complete and easier to understand than they are now.

But the worst 401(k) characteristic is shared by every plan:

It’s not a “defined benefit pension plan” – the kind that your grandparents and maybe even your parents had, which basically guaranteed a check in the mail every month for the rest of their lives.  Defined benefit pension plans still exist, but they’re increasingly rare, because they are costly for employers to maintain.  So instead of a pension, they’re offering you a “defined contribution” plan, which means that you’re allowed to contribute a certain amount of money every year – and there are no promises made regarding how long your money will last you in retirement.

What this means is that all of the responsibilities (contributions, fund selection, management, performance, and withdrawals) lie on your shoulders.  It’s all on you.

WHAT’S RIGHT ABOUT YOUR 401(k)?

Allow me to play devil’s advocate here.  If this DOL rule had not been passed, and 401(k) plans continued to operate as they have been – some being better and cheaper than others – would this be a reason to avoid them?  No.  We need to be careful not to throw the baby out with the bath water.  Let’s take a look at what’s right about your 401(k) plan.

Having one is a good thing, even if it’s a lousy plan.

If you have a 401(k) to complain about, you’re better off than many other workers in the U.S., particularly those at small businesses, where there may only be three or four employees.  Your employer isn’t legally obligated to offer any type of retirement plan, so if you have one, you may want to consider funding it – fees be damned.

High contribution limits.

For 2012, you can contribute up to $17,000 into your 401(k) account (plus an additional $5,500 for those over 50).  That’s substantially higher than IRA and ROTH IRA contribution limits of $5,000 (plus an additional $1,000 for those over age 50).

Note that 401(k) vs. IRA isn’t necessarily an either-or question.  If you have maxed out your 401(k) plan for the year, and have additional money, you may be eligible to make a ROTH IRA contribution (discussed below).  If not, consider a traditional IRA contribution (whether the contribution is deductible or non-deductible matters less than the fact that you just funded your retirement even more).

Income tax savings.

Every dollar of contribution that you make results in a lower Federal and State tax bill.  So, if you’re in the 25% marginal federal tax bracket, a $10,000 contribution just saved you $2,500 in federal taxes.  Put another way, if you took that $10,000 as income, you’d pay a $2,500 in federal income taxes.  Please note that this is tax savings by deferral; you’ll have to pay ordinary income tax on withdrawals when you retire.  And the rates and brackets could in fact be less favorable when you retire.  But, you’ll also enjoy years of tax-deferred growth on your investment.  Plus, you probably have to save for your retirement, and who doesn’t love a lower tax bill?  It’s a win-win.

Potential for matching contributions.

Some 401(k) plans offer generous employer matching contributions.  If you are on a budget, consider funding the amount needed to receive the full match for which you are eligible.  For example, if there is a 100% employer match (dollar for dollar) up to 3% of your compensation, then contribute 3% of your salary if you can afford it.  That is an immediate 100% return on your contribution.

Monthly contributions force you to save in both up and down markets. 

Once you’ve committed to making contributions, they’ll quietly come out of every pay check, and hopefully you’ll forget about it.  That way, in any stock market environment, you’ll continue to make contributions.  Why would you keep buying in during down markets?  Because the shares are on sale!  You’re buying more shares at a cheaper price (with your fixed monthly dollar contribution), and fewer shares at a higher price (when the market is up).  This concept is known as “dollar cost averaging”.

Possible ROTH 401(k) option.

Some 401(k) plans now offer a “ROTH” option, which allows you to forgo a tax-deduction on your contribution in exchange for enjoying tax-free growth on that money when you retire.  It works just like a ROTH IRA.  Contributions are made with after-tax dollars, so you pay income tax on your contribution, but withdrawals during retirement are tax-free.   The limitation with a ROTH IRA is that your eligibility is determined (limited) by your income.  (2012 ROTH IRA eligibility begins to phase out for Single filers when Modified Adjusted Gross Income hits $110,000, and ends at $125,000; the MAGI range for Married Filing Jointly filers is $173,000 – $183,000).  So there are two great features of a ROTH 401(k):

  1. No income eligibility restrictions – perfect for high earners who are ineligible for ROTH IRAs;
  2. Higher contribution limits than ROTH IRAs – $17,000 vs. $5,000.

ROTH 401(k)s are an excellent way to quickly build up your “tax-free” retirement assets.  Why would anyone pay income taxes now on that income than later?  Because income tax brackets and rates may be more favorable now than they will be when you retire.

Borrowing from your account is an option.

Emergencies happen.  And when they do, you need money from the cheapest, least painful source of money you can find.  So, for example, if your emergency fund is tapped out, if you’re unable to get a personal loan, and there are no other options, here is one.   Simply put, most plans allow you to borrow the lesser of $50,000 or one-half of your account balance.  There are risks and restrictions.  The loan pay-back schedule typically starts immediately, the payback is with “after-tax” dollars, and if you leave your job (for any reason), the full loan usually needs to be paid back within 60 days.  But it does provide you with flexibility in an emergency.  From a tax and expense perspective, borrowing from your 401(k) account can be more favorable than making a withdrawal from an IRA (income tax and a 10% penalty if you tap the IRA and you’re younger than 59 ½).  Always consult with your tax or financial adviser if you are considering a 401(k) loan.

Favorable “separation of service” withdrawal options.

If you are over the age of 55, you can avoid the pre-59 ½ early withdrawal penalty (of an additional 10%) if you separated from service after attaining the age of 55.  This feature is timely, relevant, and valuable, particularly for workers age 55 and over who are laid off one or two years before they had planned on retiring.  If you were in this situation, you could make withdrawals from your 401(k) account without incurring the pre-59 ½ early withdrawal penalty.  You would still owe ordinary income tax on your withdrawal.

Hardship withdrawals.

You are allowed to make a “hardship withdrawal” from your account if certain circumstances are met:

  1. There must be “immediate and heavy financial needs”;
  2. The funds must not be reasonably available from other sources.

What this means is that if there situations like medical expenses, tuition payments, or payments necessary to prevent the eviction from your primary residence, you may be able to make that withdrawal.  This provision does not necessarily mean that you’ll avoid the 10% pre-59 ½ early distribution penalty, but the money may be available if you need it.

Always consult with a tax adviser if you are considering taking an early withdrawal from your 401(k).

Possible profit sharing contributions.

Be aware – you may think that your 401(k) plan is just a 401(k) plan, but many plans accommodate profit sharing contributions from your employer.  These are discretionary contributions made to an account by the employer on your behalf that can equal up to 25% of your compensation.   There are typical vesting periods, which means that the employer contribution only gradually becomes fully yours.  So if you leave the company, you may be leaving money on the table.  But the fact that your employer could be making contributions into your account above and beyond the employer match is a good thing all around.

You can roll your account over into an IRA when you change employers.

This is an important point that links directly to the fee issue and whether you think your plan is great or horrible.  If there is a chance that you’ll be changing jobs at some point during your career, then the issue of whether your employer’s 401(k) offering is good or bad is irrelevant.  Each time you change jobs, you can roll your vested 401(k) balance into an IRA – at the location of your choice, and typically with a much larger selection of investments than your current plan offers.

NOT ALL BAD, RIGHT?

If you’re not there yet – if you have not yet started saving or haven’t saved enough – then use every savings vehicle available to you (to the extent that you can afford it).  Even if it’s a 401(k) and the fees drive you crazy.   You may end changing employers after a few years.  Wouldn’t you rather do so with thousands of dollars of your tax-deferred savings?

Try to envision the day you retire.  Are you going to blame the fee structure of past 401(k)s for the fact that you didn’t save enough?  Don’t let that be you.  You have an opportunity now to take control and make decisions that can have a very positive impact on your future.   Take that opportunity.

DISCLOSURE:  I am a financial adviser, and my firm DDO Advisory Services, LLC offers retirement plans for self-employed individuals and small business owners. As of February, 2012, none of those plans are 401(k)s.  That is subject to change at any time.

This essay was meant to cover some features of 401(k) plans.  It is not an exhaustive primer on every feature of 401(k) plans.  The subjective statements are my opinion, and should not be construed as advice of any kind. 

Daniel D’Ordine, CFP® is the owner of DDO Advisory Services, LLC, a full service financial planning and investment advisory firm in New York City and Rhinebeck, NY.
Follow me @DDOadvisory.

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