Buzz
The 401(k)—a staple for retirement savings in America—has only been around for just over 40 years. Introduced by the Revenue Act of 1978, it allowed individuals to defer compensation tax-free starting in January 1980. Since its inception, it has significantly transformed the landscape of retirement planning, for better or worse.
Today, enrolling in a 401(k) plan is nearly automatic for most people in corporate jobs. It’s become the primary way to save for retirement, especially as pensions have become rare outside certain public sectors. And if your employer offers a match (contributing funds to your 401(k) account), that’s essentially free money—why pass it up?
However, not all 401(k) plans are created equal. Simply enrolling in one just because it’s available may not always be the smartest choice. If you’re invited to participate in a 401(k), here are some factors to consider before deciding if it’s the right option for you.
The Fees Are Steep
Many people are surprised to learn that 401(k) plans can carry significant fees. Most of these fees are completely valid, according to Mark Weber, tax director at CliftonLarsonAllen, a CPA and financial advisor. “A typical plan includes various required costs,” he explains. “These include direct investment costs, fees for the record keeper (who maintains participant records to track account values), and platform costs. The 401(k) provider may pay commissions to sales representatives, but these should come from their fees, not your investment returns.”
Additionally, most 401(k) plans are required to provide investor education (the seminars employees often attend to learn about their investment options and other features of the plan) and comply with numerous regulations, all of which come at a cost. In other words, a 401(k) can be an expensive benefit.
How to Determine When a 401(k)’s Fees Are Too High
So, when are 401(k) fees considered too high? A useful guideline is to total up all the fees listed on your statements or the plan’s website. If the total exceeds 1.5%, the plan may not be the best investment choice for you.
One aspect to consider when reviewing a 401(k) plan’s fees is what’s referred to as revenue sharing. While most 401(k) plans directly cover necessary administration fees—deducted transparently from your account—revenue sharing involves indirect payments made by the plan investments. These fees are often more difficult to measure and increase with the size of your account, potentially becoming a significant drain on your retirement savings over time.
The plan lacks flexibility
A 401(k) plan invests your money in a tax-deferred way across a variety of investment options, and having more options generally benefits you. “You should assess the available fund choices to see if they provide sufficient variety in terms of asset allocation and cost,” advises Weber. “An ideal 401(k) will offer a mix of equity funds covering multiple asset classes (large cap, mid cap, small cap, international, emerging markets, etc.), alongside fixed income options (such as government bonds, corporate bonds, emerging market bonds, etc.). The plan will often include a money market option and potentially age-based funds, like a retirement 2030 fund.”
Most 401(k) plans offer limited investment options. While more options are preferable, the average plan offers around a dozen choices. If your employer’s plan offers only a few (perhaps just three), it might not be worth your consideration.
The company match is insufficient
One of the most advantageous features of a typical 401(k) plan is the employer match. While the details of the match vary from plan to plan, it is generally calculated as a percentage of both your salary and your contributions. For instance, your employer might provide a 100% match on the first 6% of your salary. This means if you contribute 6%, your employer will contribute the same amount. Employer match formulas can range from highly generous to not so generous, but regardless of the size, it’s essentially free money, so take advantage of it if you're participating in the plan.
If your employer provides a small match or none at all, this doesn’t automatically disqualify your 401(k) as an investment option, but it is a critical factor to evaluate. If there’s no match and additional issues exist—such as high fees or limited investment choices—this may suggest that the plan is not worth participating in.
There are significant delays in eligibility or vesting schedules
Two important factors to consider when evaluating your 401(k) plan are the eligibility and vesting schedules. If your employer advertises a 401(k) benefit, but you’re not eligible to participate for an unreasonable length of time—such as a year or more—this could be a sign that you should consider taking charge of your retirement savings in the meantime.
Another thing to check is the duration of the vesting period. When an employer matches your 401(k) contributions, that matched money isn’t immediately yours. Most plans have a vesting schedule that gradually gives you full ownership of those funds, usually based on your length of employment. Vesting periods typically range from 2 to 4 years, so if you leave the company before meeting this timeframe, you forfeit the employer match.
Ideally, a 401(k) plan with no vesting period—where all the funds are yours from the start—is the best scenario. However, if there is a vesting period, ensure that it’s not excessively long.
Options besides your company’s 401(k)
What should you do if your employer offers a 401(k) that doesn’t seem like a worthwhile investment? Fortunately, you have alternatives to consider.
“If you find that a plan isn’t appealing due to poor investment options, high fees, or no employer match, you can explore saving independently,” advises Weber. “You could consider contributing to an IRA or a Roth IRA. A traditional IRA may be tax-deductible based on various factors, but if not, you can still contribute on a non-deductible basis.”
Remember, a 401(k) allows you to contribute much more than an IRA; for 2023, the contribution limits are $22,500 for a 401(k) and $6,500 for an IRA (though limits may vary depending on age and other factors). Even if your 401(k) isn’t great, it could still be the better choice. But if your 401(k) is truly subpar, an IRA might be the smarter long-term option.
