When I evaluate a 401K for a client, I assess four dimensions of the plan:
1. What are the investment options?
For most people, the best 401K investment option is a low cost target date fund. If your plan does not offer this, the next best alternatives are low cost stock and bond index funds, with US and international options, as you can use these to replicate a target date fund. If none of these low cost funds are available, your 401K is already in danger of a failing grade.
2. What are the fees?
Fees matter greatly, especially over the long term horizon of retirement investing. The “operating expense ratio” of the underlying mutual fund(s) is the key number to focus on. Fees under 0.20% are reasonable; fees over 1% are unjustifiably high; fees between 0.20% and 1% are higher than necessary and indicate your employer is not doing the best it can. There may be other expenses such as distribution and administrative fees but the primary focus is the operating expense ratio.
3. Is there an employer match?
There is no standard expectation. Many employers offer no match at all, while others may match 25% to 100% of your contribution. Treat the match, if any, as an extension of your overall compensation and also view it in the context of the fees, which are like a negative match.
4. Is there a Roth option?
In addition to my advocacy of target date funds and low fees, I recommend using a Roth (instead of a pre-tax account) in nearly all circumstances. Some 401K plans offer this option but many don’t.
Once you assess all four of these dimensions, you can make a reasonable judgment about whether you should use your 401K plan or divert your retirement savings to a Roth IRA instead. Because of the convenience and consistency of a payroll deduction and its higher annual contribution limit, I usually recommend that people use their 401K, unless it gets a failing grade because of:
- poor investment choices
- high fees
- no match
- no Roth option
If your 401K plan strikes out across all these dimensions, you may want to opt for a Roth IRA even if you cannot do payroll deductions and the annual contribution limit is lower. If you want to save more than the maximum contribution allowed by a Roth IRA, then your imperfect 401K will be the next best option after you max out your Roth IRA.
Need a retirement review or help assessing your employer’s 401K? Get in touch.
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PS — I’ve previously written about related topics: