The 401(k)—the most common way Americans save for their retirement years—is only a little over four decades old. Established by the Revenue Act of 1978, the 401(k) became a way to defer compensation tax-free starting in January 1980. Since then, retirement has never been the same, for better or worse.
Today, participating in 401(k) plans is almost automatic for anyone with a corporate job. It’s the primary way to save money for your golden years (since pensions are increasingly rare outside certain public sector fields), and if there’s a company match (meaning your employer contributes money to your account as well) it’s free money—why wouldn’t you want to take advantage of that?
But not all 401(k) plans are created equal, and blindly participating in one just because it’s there isn’t always the best course of action. If you’ve been invited to participate in a 401(k) plan, here’s what to look for to determine if it’s the right decision.
The fees are high
Many people are surprised to discover that 401(k)’s can include a lot of fees. Most of them are perfectly legitimate, according to Mark Weber, tax director at CliftonLarsonAllen, a CPA and financial advisor. “A typical plan will have several costs that are required,” he notes. “Direct costs of the investments, costs for the record keeper ([who] maintains the records for all participants so they can determine the value of their accounts), and the costs of the platform. The 401K provider might pay a commission to a sales representative, but this should come out of their fees, not the investment returns.”
Additionally, most 401(k) plans must offer investor education (those annual or biannual seminars many employees attend to learn about their investment and other plan options) and adhere to a lot of compliance rules, all of which has to be paid for. In other words, a 401(k) can be an expensive benefit.
How to know when a 401(k)‘s fees are too high
So how high is too high for 401(k) fees? A good rule of thumb is to add up all the fees listed on your statements or the plan’s website. If they amount to more than 1.5%, investing the plan might not be the right move.
Another thing to look for when evaluating a 401(k) plan’s fees is what’s known as revenue sharing. Most 401(k) plans pay the necessary administration fees directly—deducted from your account in a transparent way. Revenue sharing is a form of indirect payment culled paid by the plan investments, which makes them a lot harder to quantify—and they grow with the size of your account, which means they can become a big drain on your retirement savings over time.
The plan offers no flexibility
A 401(k) plan puts your money in a tax-deferred manner in a range of investments—and the more choices you have, the better. “You should look at the fund choices to determine if there are adequate choices in terms of asset allocation and cost,” notes Weber. “A good 401k will have a selection of equity funds covering many asset classes (large cap, mid cap, small cap, international, emerging markets, etc.) as well as fixed income (government bonds, corporate bonds, emerging market bonds, etc.). The plan would typically also have a money market-type choice and possibly some age-based funds—for example, a retirement 2030 fund.”
Most 401(k) plans are fairly limited in the investment options they offer. More options is better, but on average there are about a dozen choices. If your employer’s plan only has a handful of investment options (maybe as few as three), it might not be worth your time.
The company match isn’t great
An employer match is one of the most valuable aspects of the typical 401(k) plan. The specifics of an employer match formula vary from plan to plan, but they’re typically expressed as a percentage of your annual income and your personal contribution. For example, your employer might offer a 100% match up to 6% of your salary, meaning if you contribute 6% to your 401(k) your employer will match that amount. These formulas can range from very generous to very not generous—but no matter how large or small the offered match is, if you’re going to participate in the plan you should grab it, because it’s free money.
If your employer offers a miserly match or no match at all, that doesn’t automatically mean your 401(k) isn’t worth investing in, but it’s a big factor to consider. If there’s no match and there are other concerns—high fees, few investment choices—that might indicate this particular plan might not be worth participating in.
There are long eligibility delays or vesting schedules
Two final aspects of your 401(k) plan to look at are the eligibility and vesting periods. If your employer trumpets a 401(k) benefit but you’re not eligible to participate for an unreasonable period of time—a year or more—that’s a sign you might need to take your retirement savings into your own hands, at least temporarily.
Something else to look for is the length of the vesting period. When an employer matches your contributions to a 401(k), that matching money is not yours immediately. There’s typically a vesting schedule that slowly gives you full ownership over those funds, typically tied to the length of your employment. Common vesting periods can be anywhere from 2 to 4 years, which means if you leave the company before you’ve worked there for at least that long, you don’t keep the company match.
Obviously, a 401(k) plan with no vesting period at all—meaning all the money is yours from day one—is best. But if there is a vesting period, make sure it isn’t unreasonably long.
Alternatives to your company’s 401(k)
So what can you do if your employer offers you a 401(k) that doesn’t look like a good investment? The good news is, you have some options.
“If you decide a plan is not attractive because maybe it has poor investment choices, high costs, or no employer match, you can consider saving on your own,” suggests Weber. “This can be done through an IRA or a Roth IRA. A traditional IRA can be tax deductible depending on a variety of factors. If not, you can always contribute on a non-deductible basis.”
Keep in mind that you can contribute a lot more to a 401(k) than an IRA; the 2023 limits are $22,500 and $6,500, respectively (there might be different limits depending on your age and other circumstances), so even a mediocre 401(k) might be the better choice. But if your 401(k) truly stinks, an IRA might be a better long-term choice.
