We have all been told since our first job that saving for retirement through the workplace makes sense. By deferring a portion of your salary while you are working, you can not only make solid and notable strides toward funding your future, you can save on your taxes today.
That's because 401(k) plans - and their less well-known sister, 403(b) plans - are "pre-tax" plans. If you made $140,000 and deferred $15,000 to your company retirement plan, you would be taxed as though your salary was $125,000. Any gains in the plan are not taxed until you begin to withdraw funds, presumably later in life when you are retired. Chock that one up to the "no brainer" category, right?
Well, yes and no. [There are no yes or no answers in this field; it's why economics is called the "dismal science."] Nine times out of ten you will want to take advantage of this type of tax-deferred savings. At an absolute minimum, if you work for a company that matches any of your own contributions, by all means you should participate - failing to do so, at least to the maximum of the company match if you can, is equivalent to throwing away free money.
Let's talk about two of the times (there are others) when you may want to reconsider using your 401(k) as a primary retirement funding vehicle (if you work in the Pentagon, we'll call this your PRFV). The second is more prevalent, so skip ahead if you're time constrained.
The first instance where it makes sense to forgo a 401k is if you are nearing retirement and you expect your marginal tax rates to stay the same or increase in retirement. Remember, long-term capital gains and qualified dividends are generally taxed at lower rates than income, so if your salary is lower (or maybe you've gone part-time), and your tax rates will increase in retirement because of Social Security, a pension or other income, take the tax hit now and pay lower rates than you would later, in retirement. Remember, all funds (whether original contributions or gains) withdrawn from a 401k or 403b and non-Roth IRAs are subject to ordinary income taxes at the state and federal level at the time of distribution.
The second and more likely reason why you might hesitate to fully participate in your company's 401k plan is fees. A long-time client of mine just switched jobs, so we were reviewing his new plan and found that the annual expense ratio for the "right" investment portfolio was at least 2.28%. That is utterly outrageous; although sadly, it is not uncommon. [There's a ditty in here somewhere: "If your plan costs start with two, you, my friend, are screwed!"]
So how much is "too much"? The first thing to know is that small plans - those with total assets of less than $10 million - are more expensive, simply because the plan maintenance costs are spread over fewer employees. A recent Deloitte Consulting study for the Investment Company Institute found that the typical annual fee is 0.67%, but for small companies the average cost is 1.27%. A similar study by the trade magazine Plan Sponsor showed the average plan cost for a plan with 50 participants and $2.5 million in assets was 1.46%.
The good news is that the figures are declining, mostly because of regulations that now require making information on expenses available. The bad news is that a whole lot of smaller companies have not taken the time to look at their plans to see what they and their employees are paying. Two types of folks are happy about that: (1) the insurance companies and large brokerage houses, which are often the ones who are charging the usurious fees; and (2) plaintiffs' attorneys, who are seeing this employer breach of fiduciary duty as ripe pickings for class action lawsuits. [If you own a company with a 401k plan, then you are a fiduciary, and that's a high standard! This email address is being protected from spambots. You need JavaScript enabled to view it. to see if you are at risk!]
Mark my words: there will be a spate of lawsuits in the coming years that relate to exorbitant fees in 401k plans. If you are a fiduciary, please take a look at your plan - for your own sake and for the sake of your employees. The 401k world is changing, don't be left behind!
If you are not an employer fiduciary, but you're interested in reviewing your 401k holdings (and expense ratios) or consider other retirement planning, call me. I'd be happy to take an objective look and let you know if you are doing all you can to prepare for a successful retirement.
