Saving for retirement is a lot like going to the dentist. We all know we should do it, but it’s easy to procrastinate because it’s painful and boring. As intimidating as investing is, a 401(k) is a great start and a great savings motivator. 401(k)s are far from perfect, though.
First, though, despite common complaints about 401(k)s, if your employer offers one, you should sign up for it. Many employers offer a match, which means they’ll match a percentage of everything you save in the 401(k) plan, up to a point. That’s free money, so you want to take as much of it as you can. In other words, you want to save enough to maximize the match. They may not be perfect, but they’re better than nothing, and for many people, that’s the alternative.
The Fees Are Too High
Maybe the biggest complaint about 401(k)s is that they come with costly fees. In the investment world, these fees are called expense ratios. The expense ratio is the operating cost of the investment and it’s measured as a percentage of the investment. Firms like Vanguard and Fidelity charge less than 0.10% for many of their investments. 401(k)s, on the other hand, often have expense ratios that are as high as 1.5 percent.
The trouble is, there’s nothing you can do about 401(k) fees, because you only get so much control over the investments you pick. “But a measly percent? That’s nothing,” you might say. “What’s the big deal, cheapskate?”
You’re right. It’s a small percentage. Tiny! Over time, though, 1.5% can add up to a substantial amount. Let’s say you invest $100,000 and, over 20 years, you get a return of seven percent. With a 1.5% fee, you’ll net $291,000. Not bad. But with a fee of only 0.10%, that same investment is $379,799. That’s a $88,000+ difference.
This is precisely why so many investors hate 401(k)s: the fees are out of hand. You can use this investment fee calculator to compare expense ratios. And if you don’t know how high your 401(k) expense ratios are, you can either look for it on your statement or use a tool like FeeX to analyze your portfolio to help you figure it out.
This isn’t to say you shouldn’t invest in your 401(k) at all. Again, you want to save enough to get the match. After all, free money is still an awesome deal, even with the fees.
Once you squeeze all you can out of that employee benefit, though, there’s little point in saving more in your 401(k). At that point, it probably makes more sense to open your own Individual Retirement Account (IRA) and save your money there, in a long-term, ”set and forget” investment portfolio. This way, you can buy cheaper investments.
Your Investment Options Are Limited
When you spend more money on something like a pair of shoes or a mattress, you usually get better quality. That’s not always the case with investments.
A higher expense ratio is not a good indicator that your investments will perform any better than the ones you could pick on your own. In fact, it’s a common complaint that 401(k) funds are actually worse than the funds you could pick on your own. There’s also the matter of diversity of fund and investment types. Basic stocks and bonds are a good place to start with investing, but it’s a good idea to invest in other stuff, too, and most 401(k)s keep your eggs in just a few baskets. As Investopedia explains, they’re designed to be simple, not diverse.
Look at your 401(k) statement to see exactly what kind of funds you’re invested in. Tools like Personal Capital and Mint Investments can help break it down for you, too. Personal Capital will tell you what kind of investments you own compared to what kind of investments you should own, based on your age and risk tolerance. Once you figure out what your portfolio should look like, you should check your 401(k)’s options to see if any comparable investments are available. For example, if Personal Capital suggests more International stocks, you can see if your 401(k) offers an international stock fund. If it doesn’t, you can use an IRA to buy the investments you need.
That “Free Money” Isn’t Exactly Free
It’s nice of your employer to offer a 401(k) match, but it’s not entirely altruistic. Companies that offer employer matches often pay lower salaries, according to data from the Center for Retirement Research. This is especially true for higher income workers (the top 40% of the income distribution.) In their report, the Center for Retirement Research writes:
…among male workers, an additional dollar of employer 401(k) contributions replaces 90 cents of wages for those with high incomes, but only 29 cents for those with low incomes…Among female workers, an additional dollar of employer 401(k) contributions replaces 99 cents of wages for those with high incomes, but only 11 cents for those with low incomes. These results support the notion that the fringe benefit/wage tradeoff can vary for workers at different income levels. For high-income workers, additional 401(k) contributions are almost fully offset by lower wages.
Also, as former hedge fund manager and author James Altucher points out, you also have to be fully vested to get the money. Employers don’t just invest all of your money at once. They sit on it and spread out the benefit over the years, up to six years total. In other words, you might have to stay at your job for six years, otherwise, this “free” money goes away.
You Don’t Get to Choose Your Tax Advantage
Any retirement plan has a tax advantage, but there are two specific types of benefits. Some retirement plans, like Traditional IRAs, are tax-deferred. This means you can deduct the amount you save from your income taxes. In other words, you’ll pay fewer taxes now, which is great if you need to save money now. You’ll still pay taxes on the amount you save (after all, Uncle Sam wants his money), but you’ll pay it when you withdraw the cash, presumably when you retire.
Other retirement plans, namely the Roth IRA, don’t offer this advantage. Instead, they offer tax-free growth, which basically means since you pay taxes as normal now, but you don’t pay anything when you withdraw your money at retirement. The money you earn on your investment grows tax-free. It’s a pretty good deal, and most experts recommend the Roth for tax-free growth.
With a 401(k), you have a tax advantage, but it’s usually the tax-deferred option. While Roth 401(k)s are becoming increasingly common, in many cases, you don’t get to choose—you have to defer your savings and you have to pay taxes down the road. In other words, when you withdraw the money in your 401(k) plan, you’ll owe taxes. Don’t get it wrong, a tax advantage is still a good thing, but it’s just one more complaint about the 401(k): you can’t always choose your tax advantage.
If you want to balance things out, though, you could open a Roth IRA in addition to your 401(k). We’ve already told you it’s a good idea to open an IRA to diversify your portfolio and escape crazy high fees, so you might as well choose a Roth IRA to get the full benefit of tax-free growth.
Again, 401(ks) are useful for jumpstarting retirement savings. They motivate a lot of people who otherwise wouldn’t think about investing to start saving for their future. They also make it easy to invest. There’s a trade-off for that simplicity, though. When you know what you’re dealing with, you know how to work around its drawbacks and limitations.