What’s Wrong With Your 401(k)? (If anything)
January 26, 2019
There currently are over sixty million Americans that are active 401(k) participants, and well over 500,000 total active 401(k) plans offered by employers in the United States. Despite these high numbers, usages could be higher, as the US Census Bureau estimates that only 41% of all employees with access to a 401(k) plan utilize it, with even less funding it fully.
Many who do utilize their 401(k) plans, do so to their great advantage. In fact, just looking at Fidelity 401(k) plans, there are over 168,000 individuals who have over $1 million saved. For many, the best savings and retirement options available are 401(k) plans.
Despite their growing popularity and being the principal retirement vehicle for most Americans who save, the plans offered by employers are often highly flawed, which ultimately costs both employees and employers. The largest reason so many “bad” plans are out there is primarily due to a lack of education on the topic and employees’ perspective that they have little to no say in the plan their employer selects or offers. In the coming columns, we intend to help remedy all these issues by providing some basic education on 401(k) plans and equipping employees and employers with the means to evaluate their current plan and how to find a better offering.
Specifically, we’ll address:
- What is a fiduciary, and why do I care?
- How do I evaluate my 401(k) plan?
- What investment options should be in a plan?
The rest of this article is going to provide some basic information on exactly what a 401(k) plan is, why your employer should offer one, and why you should be participating in it if there is one offered.
What is a 401(k) plan, and why do I care?
Simply put, a 401(k) plan is a special savings and investment plan that gives employees a tax advantaged way to save for retirement. 401(k) plans offer many benefits over a typical savings account, including:Employer Match – Most (but not all) employers offer something call an “employer match,” up to a certain dollar or percentage amount of what the employee contributes. For instance, your employer may offer a dollar for dollar match of the first 6% (this is the most common matching program). This means if you make $100,000 per year and save 6% ($6,000) your employer will match that $6,000 and give it to you in your 401(k) account. So, by saving $6,000 of your own money (from your salary), you actually are saving $12,000.
If you save over $6,000, then the match stops. If you save less than $6,000, the employer will still match what you save, but will not provide any more. Therefore, if you only save $4,000 of your salary, instead of $6,000, your employer will only match that $4,000 and you will have left $2,000 on the table.
Sound too good to be true? It’s not. Employers do this for the tax savings, to attract employees, and to assist in long term savings. Despite this “free” money, over half of all employees with access to an employer match either don’t utilize it all or don’t utilize it to the maximum amount.
Many American’s don’t realize just how much difference this can make in saving for retirement. If an individual saved $6,000 per year in a tax advantage account (such as an IRA), over a 40 year working career, he/she could expect to have saved at least $1.2 million by the time of retire….not too bad. However, if the retiree had obtained that employer match, the savings would have increased to almost $2.6m. Using a standard 4% drawdown rate in retirement, that’s the difference between having $48,000 per year and $104,000 per year in retirement.
This isn’t an unlimited benefit though. Uncle Sam does have a rule stating that you cannot put more than $18,500/year into your 401(k). Tax Advantages – A 401(k) plan is named after the section of the tax code (surprise! Section 401(k)), in which it is found. When you elect to save money into a 401(k) plan, it is called a “pre-tax” contribution. This means you do not pay taxes on the money you earn before you contribute it, whereas you would if you were just using a bank savings account or certain IRAs.
What exactly does this mean? Well if you made $100,000 in 2018, and are single, you would be in the 24% tax bracket. Prior to any deductions or credits, you would have to pay just over $18,000 in taxes. However, if you funded your 401(k) with six percent ($6,000), you would have made $106,000 (don’t forget that employer match) but only paid $16,500 in taxes. Make more, save more, and pay less in taxes.
The other large tax advantage is that the account grows tax free until you start taking money out of the account. Over the decades you save for retirement, this can make a tremendous difference in the total amount available by the time retirement finally arrives. Portability – Unlike a pension plan or some other retirement plan options, your 401(k) plan is yours. In the event you leave for another job, are fired or laid off, or die, your 401(k) plan remains your (or your estate’s) property and goes with you. If/when you leave your employer, you can roll the plan into an IRA or sometimes into your next employer’s 401(k) plan.
Also, there is nothing to worry about if your employer goes out of business. The money in the 401(k) is still yours. The plan likely will be terminated, but you will be able to roll it over into an IRA without losing anything. The money is not your employer’s money, it’s yours. Automatic Savings – There is a reason why the IRS requires employers to deduct your taxes, social security, and Medicare from your paycheck before you ever see it – to make sure it happens. Very few people have the discipline to deposit their paycheck and then move money to savings (or the IRS). For some reason there’s always a “reason” to spend that money now. Whether it’s to pay bills, set aside for a vacation, or something else, retirement is just too far away to worry about now. Then people wake up and realize they just missed a decade of compounding interest.
A 401(k) contribution is automatically deducted from your paycheck. As most employees opt into their 401(k) plan at the time of being hired, they never have any issues saving or putting the money aside, as it just “happens.” Then living on the paycheck actually received becomes the way things are.
How do 401(k) plans work?
Each employer must designate certain responsible parties on the plan. These are known as the plan administrator and plan sponsor. Your employer is typically your plan sponsor and designates a specific employee as a plan administrator. Some firms designated investment committees to be the plan administrator and sometimes it’s simply the owner/president of the company. If you have questions about your plan, you should contact your plan administrator.
The plan sponsor is in charge of choosing the company the 401(k) plan will be run through. The largest provider in the United Stats is Fidelity, though it is a highly competitive market with large firms such as Charles Schwab, TIAA, T. Rowe Price, and Vanguard, all having active presence in the 401(k) space. Frequently employers can get better rates and services from smaller, independent providers. Confusingly, this service provider is also referred to as an administrator…though that differs from the administrator at your employer’s office.
Once the service provider is picked, a plan “lineup” will be created. This is typically a combination of mutual funds, ETFs, and rarely, specific stocks. A normal plan lineup has anywhere from five to twenty options. “Target Date” funds that advertise certain targeted retirement dates are common in lineups (but should be avoided as will be discussed in the near future).
Employees are then allowed to pick how their money will be invested from the lineup. Most service providers have web-based interfaces that allow employees to direct how much of each contribution they make to which investments. An employee might elect to put one half of each contribution into an S&P 500 fund and one half into a corporate bond fund. Unfortunately, very few service providers give employees freedom to pick investments outside of the fund lineup (another advantage to using smaller service providers). Each employee then receives statements from the service provider detailing the accounts holdings, plan balances, gain, and losses. Statements typically come monthly, though some are sent quarterly.
Are there different kinds of 401(k) plans?
Most employers offer traditional 401(k) plans, over 90%.
There is another type, just as there is with IRAs, and just like a Traditional and Roth IRA, there are Traditional and Roth 401(k) plans. The downside to a Roth 401(k) is the same as it is with a Roth IRA, wherein all contributions are made after you have paid taxes, rather than with pre-tax dollars.
Other than contributing after-tax dollars, Roth 401(k) plans carry significant advantages. First, the money is withdrawn tax free, even after any gains. If you have been saving for a number of years, this likely will lead to significant tax savings over a Traditional 401(k) plan. Further, after you’ve held the account a minimum of five years, you can withdraw the money, tax and penalty free. With a Traditional 401(k), if you’re not at least 59 ½, you can expect to pay a 10% penalty on top of your normal taxes.
Our next entry in this series will discuss fiduciaries, what they are, and why such designation is important (and ignored by most of the larger 401(k) service providers).
If you have any specific questions about your plan, whether you’re an employee or employer, feel free to reach out to us at anytime via e-mail (firstname.lastname@example.org) or via phone (214-800-5164).