With traditional pensions all but disappearing, the workplace retirement plan has become the bedrock of many people’s retirement savings strategy. Four out of five Americans work at a company that offers a 401k (or a variant such as a 403b). And while far too many workers still don’t or can’t contribute to their 401k, it’s a great tool for those who do, for several reasons.
For starters, a 401k is one of the easiest ways to begin investing: You don’t need a lump sum of cash to get going, and once you set it up, your savings are invested automatically – before you see (or are tempted to spend) the money. It’s also tax-deferred, which helps lower your current tax bill and allows you to invest more money sooner – funds that will hopefully benefit from years of compounding growth. And, best of all, most companies offer some kind of employer match — free bonus money to help you save.
However, not all 401k’s are created equal, and even the good ones aren’t perfect for everyone. Moreover, some 401k benefits and drawbacks are often misunderstood. Here are three myths many people hold about 401k’s, according to Scott Puritz, managing director of Rebalance IRA.
Myth No. 1: Base your target-date fund on the year you expect to retire.
Target-date retirement funds, which gradually shift into more conservative investments such as bonds as you near and enter into retirement, are generally simple, low-maintenance, and low-cost investment options. However, some experts caution that selecting a fund based on the year you plan to retire will leave you with an investment mix that’s a bit too conservative.
“For many years, the standard practice for retirement investing was to access your funds the day you retired. For most people this meant at age 59 and a half or several years later at 65,” says Puritz. Now that people are living much longer on average, he says, retirement investors should instead be aiming to withdraw funds in their mid-70s – and selecting a target-date fund to match.
Myth No. 2: Most 401k plans offer good investment options and control.
A 401k may be the simplest way to invest, but that doesn’t mean it’s the best one. Because it’s administered by your employer (or whatever third party they’ve contracted to handle it), you’ll typically have only a few basic investment options – such as a handful of potentially costly, actively managed mutual funds – and limited control over them.
“Investors are often put in specific investment vehicles that are not in their best interest,” Puritz says. If your 401k offers good, low-cost index funds, then by all means, take advantage of them. Otherwise, you might be better off contributing just enough to max out your employer match, and then investing the balance of your retirement savings in a traditional or Roth IRA, where your investment options are virtually unlimited.
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Myth No. 3: Your 401k is a low-cost way to invest.
A 401k may be simple, but simple doesn’t always mean cheap. “In reality, 401k plans are one of the most expensive investment options,” Puritz says.
Cost is the single biggest predictor of an investment’s future returns – the less you pay the better – and many 401k’s carry high or hidden fees that eat into your investment gains year after year.
Because many companies use a third party to manage their 401k plans – with the goal of outsourcing liability, Puritz says – administrative fees for marketing, record keeping, and other services can add up quickly. “You should never pay more than 0.5% per year in fees,” he adds.
“If consumers are looking for a way to determine their fee structure, we recommend asking their advisor in writing for all expenses applied to their retirement accounts,” Purtiz says, including fund-level and one-time fees. “Requiring an answer in writing will often lead to a more detailed response.”
The Bottom Line
While your 401k is a great starting point for retirement savings, remember that’s it’s not your only – and perhaps not your best – investing option. Contribute at least enough to get your full employer match, but keep an eye on fees, and don’t be afraid to branch out into an IRA or even a health savings account.
“A low cost structure ultimately predicts the success of your retirement savings account in the future,” Puritz says. “So remain informed on your account activity to ensure your hard-earned money isn’t being eaten away by fees.”