Kim C. Christensen                                                              
Certified Financial Planner    
Registered Investment Adviser        
Registered Investment Advisor
401K Plans

401K plans (and similar plans like 403B, profit sharing, etc.) are the primary savings vehicle for many people, and they're a significant benefit offered by companies and other organizations.  If you are self-employed, an individual 401K plan is an excellent savings vehicle (see last topic on this page).

These are some of the benefits of 401K plans:

  • Automatic saving every paycheck.
  • Tax deferral of contributions and earnings.
  • Matching contributions, if offered, and sometimes profit sharing or other employer contributions.
  • Diversified default options for people unfamiliar or uncomfortable with investing, or who don't have enough time to manage their account.
  • The possibility to have individual brokerage accounts where employees can self-direct their investments in a wide variety of funds, stocks and bonds.  (Making these available is up to the employer, who may not want to do it because of the additional fiduciary responsibilities.)
  • An employee benefit/incentive that most employees desire and look for with an employer.

 These are some of the downsides of 401K plans:

  • Expenses are often higher than they should be.
  • They are often complicated for the plan sponsors, and can be costly (see below).
  • Investment choices are often limited.
  • Plan providers and advisors are often limited to what they can recommend based on what has been approved by the company they work for.
  • The more people involved (advisor - local firm - national firm), the higher the expenses.
  • Plan providers have a fiduciary responsibility to their employees, and it's possible to get in trouble if they're not careful to provide adequate investment choices, and keep expenses for employees as low as possible. 

Things to be aware of for both employers and participants:

In general, the downsides of a 401K plan (for example, high expenses), don't outweigh the benefit of participating in the plan for most employees.  Here are some exceptions: 

  • If you have a large enough income that you can contribute the maximum amount possible ($18,000 in 2015; $24,000 for those 50 and older), there is probably no other tax-deferred vehicle for an employee than the 401K plan.  If your income is low enough to qualify for a tax-deferred IRA contribution, and you can't afford to do more than the IRA limit ($5,500 in 2015; $6,500 for those 50 and older),  you're probably better off putting those funds into a self-directed IRA due to the lower cost and flexibility. 
  • The costs associated with 401K plans can be significant, although they can be controlled if the employer is aware of where the costs come from, and the options available to them.  It is up to the employer to decide who is going to pay the costs - most of them can be paid by the employer, or taken out of participants' funds.  If the employer pays the fees, they should definitely let the employees know that they are doing this for them, and that it's an additional benefit that is not insignificant. 
  • Low cost index funds (like Vanguard®) will usually be the best choice for most investors, as history has shown that most active fund managers and investors do not beat the market, and expenses play the largest role in investor success.
  • Employers have a fiduciary obligation to ensure that appropriate and low cost funds and fees are used.  Litigation has become more common against employers who have not provided plans and funds deemed to be in the best interest of their employees.

Here are the principal 401K plan costs:

  • Third party administrator ("TPA", the party that makes sure the plan is compliant and generates the necessary tax paperwork)
  • Record keeper (keeps track of all transactions, etc.)
  • Financial advisor (helps choose the funds and advise employer and participants on their choices)
  • Plan provider (the company that puts much of the plan in place and manages many of the functions of the plan)
  • Custodian (the company that actually has possession of the funds)
  • Fund fees (charged by the fund company to cover their expenses and profit, and perhaps pay the other parties listed above)

How these fees are paid may or may not be obvious.  They are often "bundled" and passed along to the participants through higher fund fees.  Or, they may be partially "bundled", which is easier to understand, or completely unbundled and itemized.

If fees are passed along to participants through the fund fees, it is generally in the form of "12b-1" mutual fund fees.  There are many different share classes for a given mutual fund (for instance, A, F-1, F-2, R-1, R-6, etc.) and they all have different fund fees.  The lowest fund fees will have no 12b-1 fee, and the highest may have a "12b-1" fee that is 1% or more.  If a plan has $5,000,000 in assets, 1% is $50,000!

It is far better to look for a plan and provider where these expenses are clearly broken out and easily understood, and do not use funds with 12b-1 fees.  These expenses can still be taken out of plan assets, but at least everyone knows what is being paid, and where it is going.  Here is an example of typical fees for a low cost plan:

  • Plan provider/TPA/Record Keeper bundled:            $1,500 + $30/participant over 30 employees
  • Custodial fee:                                                                     0.08%/year of assets in the plan
  • Advisor fee:                                                                        0.3%/year of assets in the plan, negotiable
  • Fund fees:                                                                          ~0.2%/year for low cost funds like Vanguard®

For example, if you had a $5,000,000 plan with 100 participants and went with the "bundled" product and the average mutual fund fee was 1.6% per year, the total cost would be $80,000 per year.

If you went with the lower cost plan, and used index funds that had an average annual fee of .2%/year, the total cost would be approximately $32,600, a difference of almost $50,000 per year!  A plan like this should also let you choose from almost all of the available funds in the fund universe, especially low cost funds (like Vanguard®) with no 12b-1 fees.

Individual 401K Plans:

If you are self-employed and have no employees other than your spouse, an individual 401K plan is an excellent choice for a retirement plan.  There are other plans like SEP and SIMPLE IRA's, but I think the individual 401K is usually the best choice.

  • The first $18,000 of income in 2016 ($24,000 if you're over 50) can go into the 401K.  Then you can have a profit sharing component on top of this contribution that can take your total  tax-deferred contribution as high as $53,000 ($59,00 if 50 or older).
  • Contributions are not due until you file your taxes.
  • You can take out loans against the plan (up to 50% of plan assets or $50,000, whichever is less).
  • You can open up the account with any low cost provider (TD Ameritrade, Charles Schwab, Fidelity, etc.) in the market, as most if not all provide these kinds of plans.
  • You do not have the record keeping, TPA, and custodial fees like you would have in a regular 401K, although you do have to file a "Form 5500" once plan assets exceed $250,000 (in 2013).
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