How To Evaluate Your 401K Plan
Not all 401K plans are created equally. To assess your employer’s plan, consider these four dimensions:
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 “expense ratio” of the underlying mutual fund is the key number on which to focus. Expense ratios of 0.10% or less are good; fees over 1% are indefensibly high; fees between 0.10% 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 expense ratio.
3. Is there an employer match?
There is no standard. 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 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 many circumstances. Most 401K plans now offer this option but some still 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 elsewhere. Because of the convenience and consistency of a payroll deduction, I usually recommend that people use their 401K, unless it has:
- poor investment choices
- high fees
- no match
- no Roth option
What if your 401K is a poor one?
If your 401K plan strikes out across all these dimensions, you have a few alternative options to consider:
- An IRA. However, the annual contribution limit is lower and your income needs to be below a maximum amount allowed by the IRS.
- A health savings account. This is the best savings option of all but you need to be enrolled in a qualifying high deductible health plan to be eligible.
- 529 college savings plan for your kids. The tax advantages are similar to a Roth IRA but you need kids (or grandkids) for whom you’re saving for college.
- If you’re not eligible for 1, 2, or 3, or still have more money to save, then your imperfect 401K may be most sensible.
Two Other 401K Considerations
Finally, there are two lesser known features that some 401K plans offer (though most do not). These can be quite beneficial under the right circumstances.
First, is the so-called in-service rollover. If you are age 59 1/2 or older, you may be able to roll over your 401K balance into an IRA even when still employed. You may want to do this if your 401K has high fees or sub-optimal investment choices.
Second, are non-deductible contributions beyond the normal maximum contribution amount. As the name implies, these are not tax-deductible but some plans allow you to contribute up to a maximum of $57,000 per year. The big advantage is that when you leave your employer, you can roll these funds into a Roth IRA. For high income workers, this back-door Roth IRA can be quite valuable.
If either circumstance applies to your situation, check with your plan administrator to see if the option is available.