There are lots of options when considering financial investments, it can be overwhelming, so I did some digging on the popular 401(k) plan to understand the pros/cons and compared the performance of active and passive funds. What I learned is that for long term investing, compounding interest is important, but compounding fees can also have a significant impact on a portfolio's return. The company you work for may be offering a retirement plan with tax incentives, but if understanding the details of investing isn’t really their specialty, or concern, you shouldn't depend on them to select where to invest, especially if they haven't looked into your individual needs and retirement goals.
If you want to build a business, start a family, purchase a home, or retire early, consider carefully what your financial plan should look like. Employer sponsored 401(k) plans may seem safe but one of the issues with small retirement plans is that the characteristics aren't chosen by the employers, instead they are selected by the person selling you the plan. Unfortunately, these financial advisors have not been acting in the best interest of their clients and have been offering conflicting investment advice; including high cost, actively managed mutual funds, diminishing our portfolio's return. This issue became apparent when the US senate held hearings on new rules to make retirement investing safer for all Americans, requiring financial advisors to disclose the real cost of their investment.
The Truth About 1% Fees
401(k) plans in the United States are a 4 trillion-dollar industry and people don’t manage them for free. According to a study by AARP, 80% of people don’t know the cost of their plans, 70% of those participants believe they are paying no fees at all. According to the U.S. Department of labor 401k Fee Website, high fees and expenses can reduce your balance by about 30% at retirement.
“Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.”
The purpose of high cost, actively managed accounts is to beat the market, but studies show that investors are overpaying for under performance. It doesn’t sound like much, but 1% difference in fees would reduce your account balance at retirement by almost 30%. Many professional investors, including Warren Buffet, suggest buying low-cost index funds that match the market. 401(k) plans offer great tax incentives, and there are benefits to that, but don’t be afraid to invest in taxable accounts, especially if you may need the money before you are ready to retire. By withdrawing from a 401(k) before reaching retirement age, you will be charged a 10% early withdraw fee, and that distribution will also be taxed at your ordinary income tax rate.
When Does It Make Sense to Contribute To A 401(k)?
If your employer matches your contribution, only contribute the max amount that your employer is willing to match.
If you don’t have revolving credit card debt, otherwise pay this off first if you have monthly finance fees.
If you’re a high income earner and already have a significant amount saved for emergencies, 6 months of runway minimum.
If you don’t like the idea of mini-retirements and plan to work for money until you’re at least 60 years old.
Alternatives
Index funds are a great alternative with low fees. Ill publish a new article about where to buy index funds in a future post.
Disclaimer: This is for informational purposes only and does not intend to be a complete description of investment or financial advisory services.