Do you really know how good your 401(k) is? Do you know what your investment is earning and how much you’ll have when you retire? There are a variety of considerations, but here are some of the most important ones for determining how good your 401(k) is.
1. Contribution Limits
For 2016, you can contribute as much as $18,000 to your 401(k) plan per year ($24,000 if you are 50 or older). But if your employer plan imposes contribution limits — which the IRS permits them to do — you may not get the full benefit of that contribution.
For example, if your company limits your contribution to 20% of your income, and you earn $50,000, your contribution will be only $10,000. That’s just a little bit more than half of the maximum that you’re allowed to make.
A good 401(k) plan will allow you to contribute up to the maximum.
2. Company Match
Some 401(k) plans offer no company contribution match whatsoever. No employer is required to offer a match, but it is an excellent benefit to have. An employer matching contribution is like getting found money, and the higher the match the better the plan is.
A typical employer match is 50% of your contribution up to 6% of your income. If your income is $50,000, you can contribute up to 6%, or $3,000, and your employer will match 50% of that — 3% of your income, or $1,500. That will turn a 6% contribution into a 9% contribution.
And depending on the vesting requirements of your employer, it can represent either an immediate or deferred return on your money.
3. Vesting Requirements
Vesting applies to the employer matching contribution. Some employers offer immediate vesting — as soon as the company makes the matching contribution, the money is yours to have and to hold forever and ever.
Others use some form of vesting process, which could involve either delayed vesting until you’re in the plan for say, 5 years, or a graduated process, in which you’ll be 20% vested in each of five years.
Obviously immediate vesting makes for a better 401(k) plan. This isn’t to say that immediate vesting to be the litmus test of whether or not you go to work for a certain employer. Other factors listed here must also be considered.
Why would one employer allow immediate vesting, while another spaces that out over several years? It has to do with the risk that the employer may face in implementing immediate vesting. If the employer has a high employee turnover rate, they may be permanently giving money to temporary employees. Deferred vesting is a way of keeping employees around longer.
On the other hand, an employer may use immediate vesting as a way to attract the best candidates for jobs with the company. Immediate vesting obviously represents a convincing benefit.
4. Investment Diversification
Some 401(k) plans offer only minimal investment options. For example, they may include the purchase of the employer’s company stock, in addition to just five or six funds. There may be one fund that invests in U.S. stocks, another in emerging markets, one in value stocks, one in growth stocks, and a bond fund — and that’s it.
Those funds may be good or bad, but whatever they are, they will be the only options that you have. This kind of selection does not represent a good 401(k).
A better plan is one in which you not only have a very broad choice of fund types, but also of several funds within the same classification. That will enable you to determine which funds represent the best investments.
5. Fees and Account Cost
Costs, as it relates to 401(k) plans, can take several forms. First is the existence of an administrative or management fee. The best plans are the ones that have no such fee.
Transaction costs are another expense. These can take the form of mutual fund load fees, or even direct transaction costs. A good plan will offer you exchange traded funds (ETFs) that have no load charges or other transaction fees.
Expense ratios are another cost consideration. A good plan will favor index based ETFs, since they have lower stock turnover, and therefore lower expenses. At the opposite end of the spectrum are actively managed mutual funds.
Actively managed implies that the fund will do a significant amount of trading, and that will increase investment expenses. A bad plan will be dominated by such funds.
6. A Roth 401(k) Option
A Roth provision gives you the ability to add income tax diversification to your retirement planning. The money that you have in your basic 401(k) is merely tax-deferred, not tax-free. This means that when you retire, distributions from the plan will be added to your income, which will create an income tax liability.
A Roth option will allow you to make nondeductible contributions to the plan, that will accumulate investment earnings on a tax-deferred basis, but the distributions will not be taxable. This will include both your contributions to the plan, and the investment earnings accumulated on them. It will ensure that at least some of your retirement income will come to you without tax consequences.
This provision may be more important than you might realize. Income streams coming from multiple sources can leave you with a higher income in retirement than you might expect. That higher income will result in a greater income tax liability. A Roth 401(k) offers at least some remedy to that situation.
What to Do if Your 401(k) Isn’t a Good One
You can always lobby the plan administrator to see if constructive changes can be made to the plan. However that can be a cumbersome and drawn out process, especially if your employer doesn’t put much emphasis on the plan.
A better option would be to redirect some of your retirement contributions into an IRA account. IRAs, whether traditional or Roth, are self-directed accounts that you invest with a brokerage firm of your choice.
That will give you the ability to choose a firm that has both wide investment selection as well as low-cost investment options.
Based on this list, how would you rate your own 401(k) plan?