How To Evaluate Your 401K Plan And What To Do With It When You Leave
When I evaluate a client’s 401K plan, I assess four dimensions of it:
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.
What To Do With Your 401K When You Leave Your Employer
When you leave an employer, you generally have four options for your 401K:
- Bad idea: Leave the funds with your ex-employer’s 401K.
- Worse: Roll over the funds into your new employer’s 401K.
- Worst: Take a cash distribution.
- Best: Roll over the funds into an IRA.
I always recommend #4.
#1 is bad because you are locked into your ex-employer’s plan and it may be a poor plan as I described above. Even if your plan has low fees and good investment options, there are additional reasons to choose #4 that I’ll mention below.
#2 is worse because once you roll over funds into a new 401K, you’re committed to your new employer’s plan for as long as you’re working there. At least with #1, you retain the option to do #4 at a later date.
#3 is the worst because by taking a cash distribution, you’ll spend the money, pay penalties and taxes, and lose the retirement savings you worked so hard to accrue. Don’t be tempted by the shiny apple.
#4 is best because with an IRA, you control the two critical dimensions of fees and investment choices. You select the financial institution to use and the fund to invest in. Do #4 every time you leave an employer.
There are three additional reasons to do so.
- Minimize complexity. I’ve worked with clients who have folders full of old 401K statements and keeping track of all of them complicates your life with no compensating benefit.
- With a Traditional plan, required minimum distributions are easier to administer if you only have one retirement account (i.e., a single IRA) from which to take them.
- You may want to do a conversion from a Traditional into a Roth IRA in the future. This is easy to do with an IRA but may not be possible from an old 401K.
Keep it simple throughout your working career. Every time you change employers, roll over your 401K into your existing IRA. It’s a one-and-done effort.