Crush Your 401(k): Everything You Need to Know and How to Avoid Fees
If you are overwhelmed by your 401K plans, it’s OK. This article will rocket your 401(k) knowledge out of this world! Making the best decisions with your 401(k) will never be easier.
The Problems with 401(k)’s
The 401(k) is a pretty complex investment option. Making the right decision feels difficult and overwhelming. Because it is.
When it comes to trying to choose the right investment, we are trying to negotiate a favorable financial future. A future where we can retire, support ourselves, and leave behind a legacy. However, there are a few things we have working against us.
- Complex 401(k) offerings
- Investment vehicles with high fees
- Understanding how and when to use a 401(k)
These things all pose pretty large barriers to good decision making. That is exactly why I am here to break it down, in detail.
First, we need to develop a greater understanding of what a 401(k) is.
What is a 401(k)?
So you may notice above that I referred to the 401(k) and investment vehicles as two different things. This is because a 401(k) is just a tax deferred account that can contain different investment vehicles.
To give you a better idea, other examples of tax deferred accounts are:
Examples of investment vehicles are:
- Mutual Funds
- Index Funds
Now it is easy to understand that different or multiple investment vehicles can exist in a single account. For example, you might have a 401(k) made of 10% bonds, 50% stocks, and 40% mutual funds.
So, a 401(k) is just a tax deferred investment account that can contain various investment vehicles.
That being said, there are some rules tied to your 401(k) account.
401(k) Rules and Regulations
As you would expect, there are a lot of rules and regulations that come along with tax deferred investment accounts. The IRS goes into great detail about these rules. In this article, we will be touching on the most important parts.
Most of the rules will pertain to either contributions or distributions.
- Contributions — anything invested in or contributed to your account.
- Distributions — anything paid out or distributed from your account.
There is also some criteria you will need to meet in order to have a 401(k) plan.
First, 401(k) plans can only be provided to businesses with employees. If you own your own business or work as a contractor, you are not eligible. However, you may qualify for an SBO-401(k).
Second, 401(k) plans are not a required benefit, but offering a 401(k) plan to employees comes along with some rules and regulations.
Participation for benefits enrollment can vary depending on employer, but if you meet the criteria of:
- Being at least 21 years of age
- Provided at least 1 year of service (detailed below)
Your employer must allow you to enroll in a 401(k) plan, if they offer one.
This does not mean you are left out as a part time employee. There are cases where part time or seasonal employees are eligible.
The rule of providing at least 1 year of service has a caveat. From the perspective of the IRS 1 year of services is equal to 1000 hours of work. So even if you work part time, but hit 1000 hours of work, you are eligible.
Some employers may have varying requirements for 401(k) enrollment, but the above are the requirements for age and service time. Still, some employers may offer benefits like a 401(k) at 90 days of service (sometimes even less!). If they do, they must state that part time employees and interns are excluded. Otherwise, they are required to provide the same benefits.
Bottom line. If you are an employee that meets the age and service criteria AND your employer offers a 401(k), they must allow you to enroll.
401(k) Contribution Types
As you can imagine, there are rules for 401(k) contributions. The contributions criteria here will apply to a traditional 401(k) plan.
To make it even more complicated, there are multiple types of contributions. First, there are employee contributions, which are contributions made by the employee. There are a few different types:
- Elective deferrals
- 401(k) Rollover contributions
- Voluntary post-tax contributions
Elective deferrals are your standard 401(k) contributions made pre-tax. Generally these contributions will be withheld from your paycheck and contributed to your 401(k).
401(k) rollover contributions are contributions from a previous 401(k) or other retirement account that are rolled over into your current 401(k) account.
Voluntary post-tax contributions are contributions you make to your 401(k) after your income is taxed. It is not for everyone, but if you are a high income earner, it may be. We won’t be covering this and the process is pretty in-depth, so check out what Matt at Mom and Dad Money has to say about it if you are interested.
Elective Deferral Contribution Rules
Now that you have an understanding of what an elective deferral is, its time to go over the rules. Here are the most important rules related to elective deferrals and age.
- 401(k) contribution limit under 50 — $18,500
- 401(k) contribution limit over 50 — $24,500
Contributions when you are over the age of 50 are called catch-up contributions. For a traditional 401(k) the current catch-up contribution limit is $6,000.
$18,500 (standard contribution)+$6,000 (catch-up contribution)=$24,500
There are catch-up contributions for other types of 401(k) plans. However, in this article we are going to be focusing on the traditional 401(k) plan contributions.
It is very important to understand that these 401(k) contributions are the maximum for an individual. If you have more than one 401(k) plan, you will need to keep up with your contributions to ensure you are not going over the max. The IRS will hold YOU accountable for any mistakes here.
Rollover Contribution Rules
Let’s talk about the 60 day rollover first. If you have a retirement account with an employer and the distributions are paid directly to you, you will have 60 days to roll over your 401(k) contributions into another account. If you happen to miss the 60 day window, there is still a chance to make a late rollover contribution.
Most of the time, this is not the best rollover method. Here is why.
A retirement plan distribution paid to you is subject to mandatory withholding of 20%, even if you intend to roll it over later. Withholding does not apply if you roll over the amount directly to another retirement plan or to an IRA. A distribution sent to you in the form of a check payable to the receiving plan or IRA is not subject to withholding.
None of us like extra fees and losing money, so please avoid having distributions paid directly to you. There is a much better option you can go with. Direct rollover.
Direct rollovers are exactly what they sound like. You roll over the balance of your current 401(k) account into a new retirement account. The account does not have to be a 401(k), it can be another retirement plan or IRA. The administrator in charge of your account will be able to make a direct payment to your new provider. There is no tax withholding for this method.
If your administrator offers to provide you with a check, you should refuse to accept. In the case that you accept a check you will likely fall into the 60 day rollover contribution category. Leaving you open the the fees discussed above.
401(k) Distribution Types
Now it is time to talk about 401(k) distributions! When it comes to distributions, we are going to break them up into 3 different categories.
- Early Distributions
- 401(k) Rollovers
Since we already talked about 401(k) rollovers from a contribution perspective, we are going to be skipping that one. However, we will be talking about early distributions and distributions. You might also see them referred to as 401(k) withdrawals.
Moving on, distributions can only be made when you meet the criteria for a distributable event. Here are the three pieces of criteria defined by the IRS.
- Employee dies, becomes disabled, or otherwise has a severance from employment
- Plan ends and no other defined contribution plan is established or continued
- Employee reaches age 59½ or suffers a financial hardship
When it comes to 401(k) distributions the most important thing to remember is you never want to take early distributions.
Let’s talk about that.
Early 401(k) Distributions
I want to preface this section by saying that to cash out or take out a loan on your 401(k) is generally a BIG mistake. I do not endorse or plan to do either.
It’s like they say, patience is a virtue. That is certainly no exception here. When it comes to early distributions, you can expect to be paying some hefty fees. If fees weren’t enough, your early 401(k) distribution could also be putting you into a higher tax bracket.
Things do not get much better from there. Let’s take a look at a cash out.
Early 401(k) Distributions: Cashing Out
Cashing out your 401(k) comes with a lot of down side.
Any time you take a distribution (401(k) withdrawal) you will be paying taxes. You should expect for your employer to withhold 20% of distributions for tax purposes. These taxes are for all distributions, not just early ones. That being said, there is an additional 10% penalty for early withdrawal.
Another thing to consider is, your distributions could put you in a higher tax bracket.
Why is that?
The distributions are considered taxable income. So it will be added to any taxable income that you already have, potentially placing you in a higher tax bracket. If you are low on cash and think that cashing out is going to help you, think again.
To recap reasons to avoid an early 401(k) distribution:
- You pay a 10% penalty
- Potentially move into a higher tax bracket
Next is another TERRIBLE idea. 401(k) loans.
Early 401(k) Distributions: 401(k) Loans
401(k) loans are also not a great idea. When borrowing from 401(k) plans you are required to pay it back within 5 years. Which sounds fine until you realize you miss out on any interest on those loaned dollars. Let’s take a look at what taking out this type of loan could look like:
- Take out a $15,000 401(k) loan (amount due back in 5 years)
- On payday, your cashflow is reduced because payments are taken directly from your paycheck.
- 6 months after your loan, you decide to leave for a better job. Your loan repayment is now due in 60 days.
- Unfortunately, you do not manage to complete your loan repayment. Now the government will be taxing you at your current tax rate plus the 10% penalty. (since you didn’t repay, it’s considered a distribution)
It is always better to try to avoid scenarios like the above. A little budgeting, forward thinking, and responsibility will go a long way. If anyone in the above example had just planned ahead or waited their financial position would be much better. That is why it’s highly important to budget and create an emergency fund.
Again, borrowing from 401(k) plans is a BAD idea.
Normal 401(k) Distributions
Now that we know all the crazy and silly distributions you should not use, it’s time to talk about the one you should. There are a few ways that distributions (401(k) withdrawals) can be made when you reach retirement age (59.5 years old) for a 401(k).
According to the IRS, payments can either be periodic or lump-sum.
- Lump-sum distributions will provide you with the full benefit amount (less 20%) in a single lump sum.
- Periodic distributions will provide you with many distributions in annual amounts over your life expectancy.
One note to make, while 401(k) distributions have to wait until 59.5 years of age to avoid additional fees, distributions MUST start by April 1st of the year in which you reach 70.5 years old.
There is another interesting distribution you can take advantage of, the 72(t). It is fairly complex itself, so we will leave it out for this article, but you can click the link to learn more.
Yes, it’s the moment you have been so desperately waiting for. We will now be talking about 401(k) fees. There are tons of providers out there that use various financial vehicles for 401(k) accounts, but with so many choices making the correct choice is difficult.
Before we get started. You may also see sources refer to fees as an expense ratio. This refers to the sum of all the fees we will talk about. (except individual service fees)
The thing is, may 401(k) plans have HUGE fees that eat into your retirement. It is extremely important that you understand the fees in your plan. If you see that your plan has unreasonable fees it would make you a poor steward of your money to not say something to your employer. If your employer does not offer matching, there might even be cases where you would not want to invest in your 401(k) at all!
Tony Robbins has a video that does an amazing job talking about what these fees can do to you.
Getting Robbed of Your Retirement? | Tony Robbins
In case you didn’t watch. According to a poll by AARP 68% of people believe they are paying no fees for their retirement plan. So if you are thinking the same, you are not alone.
Before we dig in more, let’s take a look at some of the fees that your 401(k) provider may be charging. The Department of Labor has a document that talks about these fees.
There are 3 types of fees you may be paying:
- 401(k) administration fees
- Investment fees
- Individual service fees
401(k) Administration Fees
401(k) administration fees are fees that pertain to the basic daily operating costs of the 401(k) plan.
Common administrative activities include:
- Record keeping
- Legal services
- Trustee services
Some plans might even have additional fees for services like:
- Telephone voice response systems
- Access to a customer service representative
- Educational seminars
- Retirement planning software
- Investment advice
- Electronic access to plan information
- Daily valuation
- Online transactions
So my 401(k) plan might be charging me a fee for a seminar I didn’t even attend? Yes, it is quite possible.
If you are already thinking that this list of fees is asinine, thats because it is! Funny enough, the above information was taken directly from this document created by the U.S. Department of Labor.
It is probably already apparent to you that the fee disclosures are an important read. Even more importantly, providers are not required to be transparent enough about the money they are draining from your retirement.
Before you get too bent out of shape, some employers cover the cost of 401(k) administration fees for their employees. You should ask them directly.
What the DOL Says About Administration Fee Payment
Before we move on, here is a quick quote from the above referenced document. It provides some insight into how 401(k) administration fees might be paid according to the DOL.
In some instances, the costs of administrative services will be covered by investment fees that are deducted directly from investment returns. Otherwise, if administrative costs are separately charged, they will be borne either by your employer or charged directly against the assets of the plan. When paid directly by the plan, administrative fees are either allocated among participant’s individual accounts in proportion to each account balance (i.e., participants with larger account balances pay more of the allocated expenses) or passed through as a fl at fee against each participant’s account. Either way, generally the more services provided, the higher the fees.
U.S. Department of Labor — A Look at 401(k) Plan Fees
Investment fees are the fees for investment management and other investment-related services. These fees will likely be making up most of the fees in your 401(k) plan. Most often these investment fees will be a set percentage of your total investment.
Even the DOL urges people to pay attention to these fees, saying:
You should pay attention to these fees. You pay for them in the form of an indirect charge against your account because they are deducted directly from your investment returns. Your net total return is your return after these fees have been deducted.
U.S. Department of Labor — A Look at 401(k) Plan Fees
Here are some additional investment fees you might see when using the common investment vehicle mutual funds in your 401(k).
- Mutual Funds
- Front end load (or sales) charges — Made when you invest
- Back end load charges (aka deferred sales charge or redemption fee) — Made when you sell investments
- Rule 12b-1 fees — Ongoing fees for paying brokers, salespeople, and advertising. Or to pay various providers.
- Target date retirement fund fees — Fees for changing investment mix if you set a “target date” for retirement.
I am sure you are starting to realize that fees start to add up fast. Especially with mutual funds as the investment vehicle. Just a sneak peek into the future…
Mutual funds are not the most effective retirement investment. Just hang in there through the fees and we will talk about why.
But first, individual service fees.
Individual Service Fees
Individual service fees are different than the previous 2 types of fees. These fees will be charging individuals based on their specific usage of a service. Some services might include taking out a loan or executing participant investment directions.
These fees are limited to actions that individuals take on a plan. You should be able to identify potential individual service fees using the following criteria:
You make a of request of your 401(k) provider.
If you find yourself making a request of any sort, it would be a good idea to ask if an individual service fee applies.
Just one more thing on fees, I promise
Keep in mind everything we went over above. When you are paying fees for your 401(k) plan that include individual, investment, and plan administration fees you may also be paying additional fees based on the investment vehicle you are using.
To be more explicit you could pay your 401(k) provider AND mutual fund investment fees. Yes, doubling down on the fees.
I really wanted to make this perfectly clear before moving on. It is one of the big reasons that mutual funds in particular aren’t the best investment vehicle for retirement. (or really in general)
Just in case you are not sold on the idea of fees chewing up your retirement. Check out this video:
Fees Matter in Your 401(K) | Tony Robbins
Yes, I know they used mutual funds as the example. No, they still are not the best retirement investment. 🙂
If you are unsure if your 401(k) plan has fees, you can use this tool to get your answers.
It is time to move on. So, what is the best investment vehicle for retirement?
Index Funds are essentially mutual funds, but with one big difference, far fewer fees.
These funds are groups of stocks that come in all shapes and sizes, but instead of being managed, hand picked, or frequently traded, these stocks follow the market. Some examples are:
- VFINX — Index of the top 500 stocks in the S&P 500
- SWPPX — Again, an index of the top 500 stocks in the S&P
- VGTSX — Index of emerging markets outside of the U.S.
The idea behind funds like the above is, they are not heavily managed. There is still going to be some managing of the funds, but not nearly as much as you will see with traditional mutual funds.
Even well-known financial guru Dave Ramsey won’t say anything bad about index funds. If you know him, he is not afraid of being blunt. Have a listen.
Even though Dave said nothing bad about index funds, I still do not understand why he stands so firmly behind traditional mutual funds. Here is why.
Index Funds vs Mutual Funds
Comparing these two financial products can be quite a headache, luckily Standard & Poor’s did the work for us. They found that over a 15 year period (ending in 2016):
…92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.
The benchmarks referenced were index funds comparable to their mutual fund cousins. Just looking at the statistics, it’s obvious that investing in mutual funds will more often have you losing to index funds and the market. If you want more detail, click the link in the quote above.
So we now know that over a 15 year period, no less than 92% of mutual funds are outperformed by index funds. Not to mention the higher fees you will find in mutual funds.
According to Investopedia, the average expense ratio for actively managed mutual funds is .5–1%, but they warn that ratios may go as high as 2.5%. For index funds which are passively managed, the expense ratio is closer to .2%. That difference may not seem like a lot, but it is.
Nerd Wallet did a study where they found that if you invest $10,000 per year, at a 7% interest rate, at a 1.02% expense ratio. You could lose the following amounts to fees:
- $11,000 over 10 years
- $61,000 over 20 years
- $210,000 over 30 years
- $592,000 over 40 years
Now you tack on the fees for the 401(k) plan! That is a heck of a lot of money going to fees!
Keep More of YOUR Retirement Money
For every horribly verbose and complicated problem, there is a simple solution. Planning for retirement does not have to be complex, expensive, and painful. There is at least one company I know of that does an excellent job.
America’s Best 401(k) (aka ABK)
They offer the fee checker mentioned earlier that allows you to find out what your fees are. They also claim to be able to cut fees by 40% or more if your provider is on the list below.
America’s Best 401(k) also works with employers to give a side-by-side fee analysis. Or if you are an employer you can start a new plan the cost of which is extremely reasonable, below is a screenshot of pricing from their site.
In the case that you still aren’t convinced. Here is one last video that does an amazing job illustrating the problem with most 401(k) plans.
Eliminate Excessive Fees and Unnecessary Middlemen | America’s Best 401(k)
If you made it this far, I am impressed. I know that was a difficult read. Now knowing this information, you probably have a slightly more difficult life. Knowing how to do what’s best puts us on the hook making us feel like we have to do it. I hope that reading this inspired you to take hold of your retirement and demand only the best.
If you found this article helpful, please share it with others so that they can also take control of their financial future. Also, please leave a comment and let me know what you thought of the article. Was there something missing? Did you want more information? Please let me know in the comments below.
Originally published at thinkhub.co on September 10, 2018.