Investing in a 401(k) World

July 8th, 2013

If you are self-motivated, wow, this world is tailored for you. The boundaries are all gone. But, if you are not self-motivated, this world will be a challenge because the walls, ceilings and floors that protected people are also disappearing. That is what I mean when I say, “It is a 401(k) world.”…Just as having a 401(k) defined contribution plan requires you to learn more about investing in your retirement, a 401(k) world requires you to learn much more about investing in yourself. 

– Thomas Friedman, author of The World is Flat, in The New York Times, April 30, 2013

 Thomas Friedman is correct: Having a 401(k) plan requires you to learn more about investing in your retirement. If you’re stuck in an expensive plan, it could be a $100,000 mistake.

Bo Lu, co-founder of FutureAdvisor, compared two employees, one working for FedEx and one for Best Buy, contributing to a 401(k). Both were the same age (25), had the same salary ($55,000), had the same wage growth, and contributed 10% per year to their employer’s 401(k) plan. At the end of 40 years, one employee’s 401(k) balance was $87,000 higher. The difference was fees.

While a significant fee difference between large employers might be unusual, it is well known in our industry that small-employer 401(k) fees are much higher than large-company fees. The table below, compiled from data in The 401(k) Averages Book, compares the cost of large- and small-company 401(k) fees in 2012:

Avoid High 401(k) Fees with an In-Service Distribution

What are your options if your employer has negotiated a plan with high fees? One little-known solution is an “in-service distribution.” Most workers over 59½ (and some who are younger) can roll over some, or all, of their 401(k) to an IRA while they are still working and contributing to the plan.

Current law allows employees at age 59½ to roll over to an IRA (in-service distribution) without paying tax. However, the employer can decide whether or not to allow in-service distribution. Check with your 401(k) plan administrator and the Summary Plan Document (SPD) for the rules in your plan.

For those under 59½, the law permits in-service distribution of money under any of these four conditions: 1) it was rolled over into the 401(k) from a previous employer; 2) employee (but not employer) made a pre-tax contributions; or 3) employee made an after-tax contributions; or 4) account earnings. Once again, the plan is not required to allow these options.

Besides high fees, there are other reasons to consider in-service distributions:

• Fund performance. The funds offered in the plan may be poor performers.
• Fund diversification. Some sectors of the market might not be represented. For example, few 401(k) plans offer a foreign bond fund.
• Roth conversion. You might be in a tax situation in which it is advantageous to convert a portion of your 401(k) to a Roth IRA.
• Professional management. As Thomas Friedman noted, investing in a 401(k) requires you to know something about investing. With your funds in an IRA, you can get outside professional investment advice.

However, there are reasons why leaving the funds in your 401(k) might remain the best option, even if your plan is fairly costly:

• Early retirement. If you retire between age 55 and 59½, you can make penalty-free withdrawals from your 401(k).
• Working and over age 70. If you are working and over age 70 ½, you are not required to include the balance in your active employer 401(k) plan when calculating the Required Minimum Distribution (RMD). You can keep your money in your tax-deferred retirement account longer, if you do not need the current income.
• Company stock. If you hold your employer’s company stock in your 401(k), you might be eligible for a tax break. (But the rules are complicated.)

If you would like help in determining the best course for your 401(k), contact Mark Stinson at 410-461-3900 or mstinson@bwfa.com. By the way, The World is Flat is a great book!