What the heck really is a 401k, anyway?


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If you’ve ever asked yourself that question silently, don’t worry. We got your back.

A 401k is a workplace savings plan that allows you to build wealth by investing a portion of your paycheck in assets such as stocks, mutual funds, or real estate investment trusts (REITs).

It is also the primary way employers help their employees prepare for retirement, and has the added benefit of allowing an employee to invest part of their salary before taxes are taken out. Not too shabby!

While all 401k plans offer tax breaks to retirement savers, many other features of these retirement accounts differ, sometimes significantly, by employer.  Before you dive in though, make sure to pay attention to the following features of 401ks.

1) Contribution Limits

401k plans are an effective way to shelter money from taxes because your contributions are deducted from your taxable income. So if you made $50,000 last year and invested $10,000 in your 401k, you’d only have to pay taxes on the remaining $40,000. This can be a great tactic, especially for people who live well within their means and can afford to save a big chunk of their salary.

Be careful though, because you can’t just save as much money as you want. You can’t just save $45,000 out of your annual salary and live off mom and dad because Congress places contribution limits on your annual deferrals.

Yeah, unfortunately there’s no way to dodge the tax man entirely. Unless you’re an expert money launderer perhaps.

In the past year, the 401k contribution limits were $17,000 for employees, an extra $5,500 for those 50 years or older, and $50,000 overall including employer contributions in the form of matching funds and other compensation.

Still, $17,000 a year is quite substantial for many of us.

But wait, what happens if I exceed the 401k Contribution Limits?

If you contribute more money to your 401k account than you are allowed to, then you have until mid-April to return the cash you contributed. This overpayment is referred to an excess deferral, and if you received a tax deduction, you’ll have to give it back upon withdrawing the excess deferral.

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If you already used that money to buy yourself a fancy coat for the holidays…we hope you saved the receipt!

On the bright side, you shouldn’t be subject to the additional 10% early withdrawal penalty but remember that it’s your responsibility to spot the excess in your 401k contributions, not your employer’s.

If you don’t get excise the excess before the tax filing deadline in the year in which the error is made, you’ll face rigid penalties, double taxation, and might even have your entire retirement plan reclassified as non-qualified. This would have enormous financial implications if you’ve worked hard to build a solid foundation in previous years.

2) You’re using it wrong 

We live in a world where every employer offers a 401k plan, but it seems most people are just…doing it wrong.

The first problem is that many people don’t even sign up for one to begin with. Talk about leaving money on the table…especially if your employer offers a match program!

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Additionally, only a minority of people end up opening a 401k while also saving an adequate amount and investing in a properly-diversified low-fee fund.

There’s no reason you can’t be one of them!

3) The Fees

Despite all the seemingly wonderful benefits a 401k has to offer, a new study by Demos, a nonpartisan public policy research and advocacy organization, alleges that your 401k plan may be ripping you off in ways you don’t even recognize. When it comes down to it, the typical 401k will eat away nearly a third of your investment returns!

Most investors who buys mutual funds have heard of fees like the “expense ratio,” which averages more than 1% per year. Here’s the bad news: 401ks are not exempt from such fees, which cover the cost of record keeping and compliance, the fund manager’s salary, and sometimes marketing fees. While the expense ratio is publicly shared, there are other fees that, Demos found, “are nearly completely hidden from retirement savers.”

The sad truth is that investing in a 401k can be mechanical. Your employer offers it to you, and you accept without ever taking a look at what you’re buying. What if a guy jumped out the back of a van and offered you a box full of…stuff…for $400? In what world would you fork over the money without first looking in the box?!

Look in the box.

4) The Fees: Part 2

Most people have no idea what “fees” even means, which bodes ill for the power of disclosure to have any effect.

What if you defend your 401k on the basis that they only charge you 1.23%? If you think that’s really low…you’re getting ripped off, even though you do know the fee structure of your fund.

The study done by Demos shares an example fund in which a $50,000 investment earned 4.65% net. Meaning after one year, the account was worth $52,325. In reality, the fund earned more on that first $50,000. The stated expense ratio was 1.23%, so $615 in fees came out prior to that return. That means the fund actually made $2,930 gross, or 5.88% of the initial $50,000.

However, the study encourages us to look at this in another way. By expressing fees as a percentage of the gross return. To do this, take the $615 in fees, and divide it by the gross return of $2,930. This equates to a startling 20.9% of its return in fees, meaning an investor paid 20.9% for the value the fund added. But this still doesn’t take into consideration obscure “trading fees” cited by many 401k plans. According to Demos, trading fees “often cost savers as much as or more than the explicit expense ratio,” meaning this example fund probably had a “real expense ratio” of 2.46%.

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Since trading fees come out of the gross returns, we can adjust the fund’s gross, pre-fee, return to 7.11%. Meaning the fund actually earned $3,555 before fees. Your fees as a percent of gross return now?

A whopping 34.7%. Oof!

Look, there are plenty of benefits to owning a 401k. It encourages you to save and has obvious tax-deferral benefits. If you have a good match program, then you’re literally being paid to save by your employer. That’s great!

On the flip side: that money – the money that you earned – goes into an investment vehicle that you likely know very little about. It charges you fees that make it that much harder for you to reach your ultimate goal: earning a decent return on your money, enough to retire comfortably.

Think long and hard before you stick your money into a 401k!

 

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