In 1978, Congress added section 401(k) to the Internal Revenue Code in order to give employees a tax break on deferred compensation. Today, the 401(k) is the most popular retirement savings vehicle in America. Employer matches, tax-deferred growth, and relatively high contribution limits ($16,500 in 2010, $22,000 if you’re 50 or older) make these plans extremely appealing. Unfortunately, not all 401(k)’s were created equal. If you’re stuck in a bad plan, it’s important to know how to make the most of the situation.
High Costs, Lack of Fund Choices
The most common complaints about 401(k) plans relate to the choice of funds (or lack thereof). Oftentimes, especially in small or mid-size companies, investment choices come from only one or two fund families, they leave out major asset classes, and they don’t include any low-cost (expense ratio < 0.75%) or index-based funds. When you add in administrative and sales fees, this tax-deferred investment vehicle suddenly doesn’t look so great.
(read more about how high costs can put a serious dent in your retirement savings)
What You Can Do
First, it’s important to take the time to evaluate your 401(k) plan. Sites like BrightScope can help to rate your plan on several broad dimensions, but it will probably take some personal effort to uncover the hidden layers of fees and expenses, and to compare them to your other retirement savings options. Ask your plan administrator for a Summary Plan Description so that you can better evaluate your plan, and if you don’t like what you find, recruit some fellow employees to help lobby for changes.
In the meantime, if your company matches contributions, you should continue to contribute up to the matched amount before worrying about an alternative investment vehicle. In general, you should contribute to your 401(k) up to the employer match, then fund an IRA, then max out the remaining portion of your 401(k), all before making taxable investments.
If you’re out of tax-deferred investment options and feel forced to choose among poor 401(k) funds, you can minimize the damage to your retirement savings by picking the lowest cost funds that still fill a position in your asset allocation plan. For example, if your 401(k)’s lowest cost fund is a bond fund that fits into your target allocation, you could dedicate a large portion of your 401(k) contributions to that fund and maintain your overall allocation by shifting other investment accounts toward equities. Try Morningstar’s Instant X-Ray Tool if you need help reorganizing your overall portfolio while maintaining the same exposure to size and value factors.
Legislation that would place tighter regulations on 401(k) plans, including transparent fee disclosure and mandatory index fund offerings, was brought before Congress in 2009. Until such legislation is enacted, however, investors must take the time to carefully evaluate their 401(k) offerings and reorganize their portfolios to minimize the negative impact of high-cost 401(k) choices.
Reminder: Need an opinion on a risk-appropriate asset allocation? Get a FREE portfolio recommendation today!
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