If you’re like many of our clients, you have access to a retirement plan through your company. The most common type of plan we see is an employee-directed defined-contribution plan, like a 401(k) or 403(b). You probably have a 401(k) if you work for a typical company or a 403(b) if you’re in the nonprofit or educational space. But it you’re like most employees, you may have received some incorrect information (or just bad advice) about your workplace retirement plan.
To make things a little easier, we thought we would run through some common misconceptions that we hear from clients and explain how we evaluate your employer plan.
1. “I’m maxing out my plan by contributing up to the employer match.”
In most cases, if you’re under 50 and you’re not contributing $19,000 (2019) or over 50 and not contributing $25,000 (2019) then no, you may not be maxing out your contribution.
At the bare minimum, everyone should contribute to the employer match – if you don’t, you’re leaving FREE MONEY on the table. From there work toward making the maximum IRS-regulated contribution. You may not be able to put in the maximum amount right away, but if every time you get a raise, you increase your percentage contribution by at least 50% of the raise amount, your future self will thank you!
2. “There’s no benefit to contributing because my employer doesn’t match.”
Yes there is! The single easiest way to reduce taxable income – and tax bill – is to contribute as much as possible to a 401(k) or 403(b). Your money will have the opportunity to grow either tax deferred or tax-free until you need it. Not only that, but contributing to your employer plan forces you to put money away for the future – something we all need to do!
3. “I don’t pay for my 401(k). It’s free.”
There are several types of fees built into employer plans. Unfortunately, you’ll rarely, if ever, see a fee itemized for you, so most people don’t even know what fees they are paying! When we analyze your 401k, we use software that can dig in to the fees in your plan and at least bring them to light.
Excessive fees can eat into your returns over time. There are some fees that are built into the plan (e.g. administrative fees, rollover fees, etc). You won’t be able to avoid them unless your employer changes plan administrators to one with lower costs (if this is something your employer wants to do, we can give you some recommendations for lower-cost plans we like).
Outside of the plan fees, each of the investments available will most likely have a fee called the “expense ratio.” This is the internal fee that a fund charges you to manage your investment. You will never see this fee itemized on a statement. It’s deducted directly from the fund’s value. Fees in employer plans can range from around .02% to over 1%. While you can’t avoid this fee, you can choose the funds in the plan that offer fees on the lower end of the spectrum – if they’re available.
4. “I set up my contributions, so now I’m done.”
Not so fast! While it’s great that you’re contributing to your plan, now you need to choose how to invest your funds. If you don’t, you’ll money will go into your plan’s default investment option. Sometimes this investment is what’s called a “Stable Value Fund.” These funds are typically low risk and low return fixed income funds. If you’re young and can handle some risk, these are not the funds for you!
Sometimes the default investment is a target date fund that is pegged to the year when the plan assumes you’ll need the money – usually around age 65. The farther you are from the target date (the younger you are), the higher your stock allocation. As you approach the target age, the investments in the fund become more conservative, lowering the risk. By the time you’re at retirement age the fund should be comprised of mostly fixed income investments.
While this is certainly not the worst way to invest, (it does give you a diversified portfolio that should ostensibly be aligned with your retirement goal) it limits your control over your investments. During the 2008 financial crisis, many people approaching retirement found themselves in a too-aggressive position within a target date fund and their investments declined significantly at just the wrong time. Also, you need to be careful about fees in target date funds. Sometimes the plan offers the same funds that are held in the these funds at lower “expense ratios” than the target date fund.
If you’re not using a target date fund because it has a high expense ratio or you would rather have more control over the investments, you’ll need to set up your own portfolio. When we work with clients, we create an asset allocation based on their personal tolerance for risk, along with their time horizon until they need the funds, among other factors. If you don’t know whether you can withstand risk, there are some online questionnaires you can use to determine what might be an appropriate level of risk for you. From there, you can create an asset allocation that has the right mix of riskier and safer investment choices. If you want a professional assessment, we can help.
We also want to point out that while low fees are important, they’re not everything. When selecting your investments, it’s also wise to review the historical performance of the funds in the plan. All of the funds you find in an employee plan are benchmarked to an index. Check out how the fund’s performance has stacked up against the index and against other funds in the plan that track the same (or similar) indices. Historical performance is not necessarily indicative of future performance, but it can give you a clue as to how the fund might perform.
5. “The market just took a nose-dive. Better move to cash.”
Generally, after a market crash is the worst time to sell! We recommend staying true to the asset allocation your developed and only look at your plan 1 to 2 times per year to rebalance the investments that asset allocation. As you get closer to needing the funds, you’ll likely want to create a more conservative allocation. At least annually, you should make sure the asset allocation hasn’t drifted too far from your initial plan. As different investments change in value, their weights in your portfolio will change accordingly and you’ll need to rebalance. Sometimes a plan administrator will add or remove funds in the plan. When this happens, it’s a good idea to revisit your investment choices.
6. “My employer plan is terrible. It’s better to just not contribute at all.”
Even if your employer’s plan only offers lower performing investments with high fees, it’s still worth looking into the other potential benefits. You may get valuable tax benefits, and you’ll be saving for future financial independence. You could also look into contributing to an IRA, however, there are income limits for contributions and tax deductibility for most people. Also, if you’re under 50, you are probably limited to contributing $6,000/year for 2019. In a 401k or 403b, you may be able to contribute up to $19,000 and you may even get a match for some or all of your contribution. Once you leave your employer, you can leave that not-so-good plan by rolling over the account to an IRA or to a new employer’s plan.
Have more questions about making the best use of your employer retirement plan? We can help. Schedule an Introductions Call to get started.