We all agree there’s no easier way to become a millionaire than steadily investing into your 401K, right? After all, a new grad maxing out her 401K every year is all but guaranteed to retire with about $4 million dollars.
Say, you’d like $4 million! (Me too!)
So you go job hunting, survive the ringer of the interview process, and eagerly accept your new dream job. You’re excited, because you’ve found a gig in a great part of town, with exciting opportunities, and job responsibilities that perfectly align with your moral code and life passions.
…Either that, or the pay was too good to say no.
In any case, you show up on the first day, meet your friendly, smiling coworkers for the first time, and get a tour of your new home away from home. At some point, HR hands you a mountain of papers to sign, including some bit about the company 401k.
You thumb through their gigantic retirement packet, admiring the awkward stock photography on every other page. You’ve never seen so many suit wearing professionals floating against white backgrounds in your entire life. And why are they all grinning ear to ear while doing incredibly mundane tasks?
Never mind that confusion, you notice something that catches your eye. Buried among paragraphs of retirement advice that couldn’t be more boring if it tried, you see the company’s 401k’s fund options.
Excited, you scan for low fee Vanguard funds, since you’ve seen The Money Wizard type endlessly about their greatness.
That’s weird… no Vanguard funds.
You continue scanning the page, before coming to a disappointing conclusion about your new dream job’s 401k options:
They all suck.
What to do?
Should you ditch the 401K? Is it smarter to instead invest in an IRA, or even a low fee, taxable account instead?
1. Comparing Average 401k Expense Ratio and Statistics
First off, let’s determine whether your gut feeling of 401k suckage is actually true.
It very well may be – this high cost 401k dilemma is more common than you think. Unfortunately, your new coworkers aren’t likely to be much help on the subject matter.
Far from maxing out their tax benefits, the average employee:
- Contributes just 7% to their 401k
- 40% of employees have less than $10,000 in their retirement plans
- And a full 20% ignore this huge benefit all together.
But not you, you’re a Money Wizard reader. You’re all about maxing out these savings cheat codes and building as much wealth as possible. So let’s see just how your company’s 401k plan is stacking up against the average.
According to the Center for American Progress (no clue who that is either, but their sources check out):
- The average 401k expense ratio is 1% of assets managed.
- Small businesses (less than 100 employees) have an average 401k expense ratio of 1.32%.
At first glance, a 1% expense ratio doesn’t sound too bad.
Wrong! The same study showed a 1% expense ratio costs the average american $138,336 over their lifetime!
2. Fees Matter
Big time. And fees matter even more when you’re an above average saver.
Let’s consider two new grads savers. One new grad maxes out their 401k while working for a small business whose retirement program only offers funds with a 1.32% expense ratio. The other new grad also maxes out their 401k, except their employer’s 401k offers a Vanguard fund with a 0.20% expense ratio.
We’ll assume both continue maxing out their 401ks over their 35 year careers, and the market returns 7%. We’ll assume they both make $50,000 and get a 4% employer match.
Just a 1.12% difference in expense ratio cost our saver $564,00! The difference between retiring with $2.65 million and $2.08 million.
(Btw – If you’re curious, the average employer match is 3.5% of the employee’s salary, according to the Bureau of Labor Statistics. Anecdotally, the average office worker I know gets a match of 4-5%.)
3. Make Sure Those High Expense Ratios Are Actually High
The good news is the 1% average ratio is just that – an average. Most 401k plans have upwards of 10-20 different mutual funds to choose from. Looking through the mutual fund list often looks something like this:
- Option A: Some ridiculously named actively managed fund – 2.00% expense ratio.
- Option B: Another ridiculously named actively managed fund – 1.50% expense ratio
- Option Z: Reasonable Vanguard Index Fund – 0.15% expense ratio.
Choose your 401k investments carefully! In 3 minutes I saved my brother $210,000 in lifetime investment fees, just by switching his 401k to a lower cost index fund. Take that, Geico!
*In researching this article I found many disturbing instances where companies such as Fidelity and basically anyone not named Vanguard were sneakily charging fees on top of the Expense Ratio. Beware of: management fees, distribution/service/12b-1 fees, sales charges, or anything else that sounds like a fee. Yet another reason I default to Vanguard.
So, What If My 401k Still Sucks?
There are times when a 401k has no good options. If you’ve ran the numbers and determined that your 401k does in fact suck, should you look to invest elsewhere?
Standard operating procedure around here suggests the ideal wealth building plan is:
- Contribute up to the IRS allowed 401k max ($18,000 per year)
- Contribute up to the IRS allowed IRA max. Preferably in a Roth, assuming your 401k is traditional. ($5,500 per year)
- Contribute anything leftover to after-tax, low fee index funds, such as Vanguard. (As much as possible)
If you’ve established that your 401K sucks, you might be temped to shift up the order of operations to instead:
- Contribute up to the IRS allowed IRA max ($5,500)
- Contribute to an after-tax, low fee index fund, like Vanguard.
- Maybe contribute enough to get the company match from your 401K, while you curse your employer for having a retirement account with such high fees.
It’s a reasonable conclusion, but taking this approach would be a HUGE MISTAKE for most investors!
Even a Bad 401k Is Usually Better than a Taxable Index Fund
I love Vanguard, and I love low fee index funds. I’ve written about the beauty of both several times.
However, when push comes to shove, the two can rarely compete with even the worst of 401Ks. Why? Three reasons:
1. The employer match is literally free money: Some companies provide matches up to 100% of a portion of your 401k contribution. If so, this match is the only investment in the world which provides a 100% return, guaranteed.
I don’t care what fees your 401k is charging. If it means your employer is handing you a couple thousand dollars for free every single year, they’re worth it.
2. You may not stay with the company forever: If you ever leave your company for any reason, you can always roll-over your high fee 401k into a low-fee traditional IRA, at no cost to you.
In other words, high 401k fees are only temporary, while the tax benefits of a 401k are forever. Take advantage while you can, because once the tax year is up, you can never go back!
3. Those tax Advantages are huge! In a traditional 401k, you defer paying taxes on your 401k contributions for decades. By the time you eventually withdraw money from your retirement account, you’ll hardly notice the blip in taxes from your mountainside beach house.
Maxing out my own 401k every year reduces my taxable income by $18,000 and reduces my tax bill nearly $6,000. That’s an extra $6,000 I get every year, which can be invested and grown into a larger and larger sum.
Plus, like almost all of the population, I will probably retire into a much lower tax bracket than during my working days. The lower tax rate directly converts those tax deferrals into tax savings.
Meanwhile, even the best low fee index fund outside of a 401k gets hit hard by taxes. In a taxable index fund:
- Your money is taxed before you ever get to invest it (25% for most Americans).
- Then you pay taxes every year on the fund’s dividends.
- You continue to pay those dividend taxes even if you leave your employer.
- Then you ultimately pay capital gains taxes when you sell the fund in retirement.
How much does this all add up to?
A lot! Usually far more than even a high fee 401k.
Let’s compare someone paying a 1% expense ratio in a 401k versus someone who chooses to invest into the lowest fee, taxable index fund around – a Vanguard fund with a 0.05% expense ratio.
We’ll assume the market returns 7% over their 20 years at the company.
Retirement Rick invests in a 1% expense ratio 401k. Taxable Terry invests in a .05% expense ratio taxable Vanguard fund.
|Retirement Rick||Taxable Terry|
|Salary||$ 70,000||$ 70,000|
|Contribution||$ 18,000||$ 18,000|
|Taxable Income||$ 52,000||$ 70,000|
|Taxes Owed||$ 7,196||$ 11,696|
|Extra to Invest||$ 4,500||$ 0|
|Total Invested Each Year||$ 22,500||$ 18,000|
|Account Balance after 20 years||$ 845,615||$ 733,902|
In the above example, because Retirement Rick contributed to a 401k, he reduced his taxable income by $18,000 per year. This reduced his tax bill, which left him an extra $4,500 in his pocket to invest outside of his 401k, every single year!
So while Taxable Terry could only invest $18,000 into a taxable Vanguard fund, Retirement Rick could invest $18,000 in his 401k, plus $4,500 into the same taxable Vanguard fund, for a total of $22,500 invested each year.
By the end of his 20-year career, Retirement Rick had $845,615:
- $662,140 in his 401k
- $183,475 in his taxable account
At the end of Taxable Terry’s 20-year career, his taxable account (even with a lower fee) had $112,000 less.
In this scenario, Retirement Rick’s 401k could have fees as high as 2.19%, and he’d still end with more money!
Plus, after their 20-year career at the company ended, Rick could then simply roll over his 401k into a low fee, Traditional IRA at Vanguard. He’d now have the same expense ratio as Terry moving forward, plus the benefit of 20 years of tax free growth (which gave him an extra $112,000!)
The High Fee 401k Game Plan
Even with expense ratios above 2%, the 401k still wins. So when you’re back staring at your high fee 401k fund and have finished cursing your employer, here’s what to do.
- Look through the 401k’s list of funds. Even bad 401k plans typically have one or two lower fee index funds.
- If your company provides any sort of matching, definitely contribute up to the company match.
- If even the lowest fee 401k funds are less than 2% or so, continue to contribute up to the IRS allowed maximum in your 401k. ($18,000 as of 2017)
- Contemplate how much you like your job, and consider switching to an employer with a good 401k plan. 🙂
(I’m assuming you’re saving enough to max out both your 401k ($18,000) and your IRA ($5,500). If not, consider a more frugal lifestyle, and in the meantime, it’s okay to prioritize a low fee IRA over the high fee 401k, AFTER you’ve received the company match.)
Does your employer offer a good 401k option? If not, what’s your strategy?