Do you ever have a sense that you have a bad 401(k) at work? If you do, you’re not alone. While a lot of employers have 401(k) plans, many of those plans are average or worse. But if you are in such a plan, you do have options.
First we’ll look at how to evaluate a 401(k) plan. It’s much easier than you think. Then, if you find your retirement plan lacking, we’ll give you some actionable tips you can follow to make the most of a bad 401(k).
What Makes a 401(k) ‘Bad’
How do you know that you’re not just being a malcontent about your plan? Is it really bad? Here are some telltale signs:
- High fees. High fees usually come in the form of high expense ratios. An expense ratio is the industry’s term to describe how much a mutual fund charges its shareholders. An expense ratio of 1.00% means that you will be charged 1.00% of the amount you have invested in the fund each year. While that may not sound like much, even a fee of 0.50% can result in hundreds of thousands of dollars in fees over a lifetime of investing. Generally, fees above 0.25% for an index fund or 0.75% for an actively managed fund are considered too high.
- Limited investment options. Some 401(k) plans will have a single fund available for each of several sectors. This may include a US growth fund, a foreign market growth fund, a bond fund, a money market fund, and maybe two or three sector funds. The plan may also invest with a single mutual fund family, where you don’t find many attractive options. While the number of funds by itself is not critical, having limited options combined with high fees is a problem.
- No- or low-employer match. One of the biggest attractions of any 401(k) plan is the employer matching contribution. But if your employer does not offer a match, or if the match isn’t particularly generous, it lowers the attractiveness of the plan.
If your plan has any of these limits, it’s almost certainly a bad 401(k) plan. You can do your best to make the most of it, but you will have to consider other options to compensate for the weaknesses in the plan.
Talk to Your Employer
The first step should be to talk to your HR department. Particularly when it comes to investment options and fees, employers often want to know if employees are happy with the retirement plan. Changes may not occur quickly, if at all. But it doesn’t hurt to ask.
Contribute Enough to Get the Maximum Employer Match
If your 401(k) plan is wanting, then you’ll probably want to limit the amount of money that you put into it. Still, if your employer does offer a match, you should contribute at least enough to get the maximum match. For example, if your employer offers a 50% match up to 3%, then you should contribute 6% of your pay to the plan, in order to get the full 3%.
That match is found money, and you should never ignore it. In addition, the match will turn a 6% contribution into a 9% contribution. That’s always worth pursuing, even if the investment options are lacking.
Choose the Investment Options with the Lowest Fees
If your 401(k) plan charges high fees, favor the investment options that have the lowest fees. And if there are transaction costs, it should go without saying that you should not actively trade the account. You will have to view your investments within the 401(k) as mostly static positions.
Of course, you’ll have to balance out the fee situation with the quality of the investments you purchase. A high-performing investment with high fees may be preferable to a low-performing investment with low fees.
Set up a Traditional or Roth IRA
Perhaps the best solution to a bad 401(k) plan is to invest outside the plan. The best option is through an IRA, either traditional or Roth. An IRA is a self-directed plan, which means you can choose the trustee where the plan will be held. You can choose an investment brokerage firm that will offer the widest investment selection at low fees. And you can contribute up to a set limit that can change each year (see the current limits here).
Even if your income is too high to get a tax deduction on a contribution to a traditional IRA, it will still be worth putting money into an account. In addition to the fact that you will be gaining self-directed investing for the plan, nondeductible contributions to an IRA will reduce your tax liability in retirement. And the investment earnings will still accumulate on a tax-deferred basis.
A Roth IRA serves the same purpose. While the contributions are never deductible, qualified withdrawals are tax-free. A Roth has the same annual contribution limits as a traditional IRA.
Set Up a Self-employed Retirement Plan if You Have a Side Business
If you have a side business, you can set up a retirement plan for that business. There are various options available.
The SEP IRA is a common self-employed retirement plan. However, it tends to work best for people with higher business income. The SEP effectively limits your contributions to 20% of your business earnings. This can be quite generous if your business earns $100,000 and you can make a $20,000 contribution. But if your side business earns $10,000, you will be limited to a $2,000 contribution.
Better options would be either a Solo 401(k) or a SIMPLE IRA. Each allows you to contribute 100% of your income up to the plan limit. In the case of the solo 401(k) plan, the maximum contribution is $18,000, or $24,000 if you are 50 or older (these limits can change from year to year). You can also make an employer match of effectively 20% of your total business earnings.
The SIMPLE IRA has a maximum contribution of $12,500, or $15,500, if you are 50 or older (again, these limits can change each year). The maximum contribution isn’t as generous as it is for either the SEP IRA or the solo 401(k). But if your business earnings are within those contribution limits, it can be a good plan to have.
If you do have a self-employed retirement account, the combination of contributions to that account, plus your employer plan, cannot exceed $54,000 per year, or $60,000 per year if you are 50 or older. Both totals include the employer match and also can change each year.
Invest in Taxable Accounts
This can be an especially good strategy if your income is too high to make a tax-deductible contribution to a traditional IRA or to participate in a Roth IRA plan. You can simply save money in taxable investment accounts in addition to your employer-sponsored 401(k) plan.
There’s no tax deduction for making contributions to taxable accounts, nor do you have the benefit of tax-deferred investment income. But that also opens up the possibility of having tax-free income in retirement. That is, you will be able to make withdrawals from your taxable accounts without having to pay income tax on the amount of those withdrawals. (Of course, the income you earn on taxable accounts will always be subject to income tax in the year earned.)
As you can see from this list, you are not without options if you have a bad 401(k) at work. Participate in the plan at some minimal level, but maintain the bulk of your retirement assets in other accounts.
Updated August 5, 2017 and originally published August 4, 2017.