There is nothing wrong with the 401k, but there are a lot of really bad 401k plans out there. If you’ve never invested, you may not be able to tell the difference. But it is worth learning how to spot a bad 401k plan because it might be something to consider when looking at a prospective job. You can also change your behavior if you have a bad plan to improve your investing options. We’ll talk about this at the end of this article. But first, here are some things to look for in your 401k.
1. A lack of index funds.
In the world of investing, there are managed funds and index funds. Managed funds have a whole team of managers who go out and find “investment opportunities” and “seek to manage risk while providing a reasonable return.” The trouble is, the vast majority of mutual fund managers don’t do as well as the markets, and all of that research and pontificating comes with a hefty price tag.
An index fund doesn’t try to beat the markets. It just buys stocks as dictated by some index, which is a hypothetical portfolio of stocks designed to track the behavior of some part of the market. For example, in the early 20th century, Charles Dow wanted to have a way to see how the large industrial companies in the US were doing. He chose a group of large industrial companies that covered the different industrial business areas at the time and pretended that he invested an equal amount in each company. He then began to track what the value of that portfolio was compared to its value when it was formed and the Dow Jones Industrial Average was born. About 90 years later, a company started an index fund that simply bought the stocks in the Dow Jones Industrial Average, and thus the “DIAmonds” index fund was born. Unlike a managed fund, the index fund just buys what’s in the index and doesn’t need to pay a team of analysts and managers, thus the costs are a lot lower.
An index fund will typically have fees of 0.25% of assets or less. This means it will cost you $25 per year if you have $10,000 invested. A managed fund can have fees of 1% or more, meaning you’ll be paying $100 per year for each $10,000 invested. While this difference may not seem like much, it means you’ll be making about 0.75% more each year in the index fund, which will add up to hundreds of thousands of dollars over your working lifetime. A plan that lacks index funds stinks.
Hey – if you like The Small Investor, help keep it going. Buy a copy of the SmallIvy Book of Investing: Book1: Investing to Grow Wealthy or just click on one of the product links below, then browse and buy something you need from Amazon’s huge collection. The Small Investor will make a small commission each time you buy a product through one of our links.
Find a great new book
Shop DVDs
Buy your Pet Supplies
Tools and Hardware
Best Selling Toys and Games
Patio Lawn and Garden Supplies
2. A lack of diversity of funds.
As a minimum, a good plan should have:
- A total stock market index fund
- A total bond market index fund.
A better plan would also have:
3. An international stock index fund.
4. An REIT fund. (An REIT is a mutual fund of investment real-estate properties, such as apartment buildings or malls, even cell towers and storage centers.)
The best plans would also have:
5. Target-date retirement funds.
6. Small and large-cap funds. (Capitalization, or “Cap,” refers to the size of a company. Small-caps are small companies, large-caps are large companies. Mid-caps are – you guessed it – medium companies.)
7. Growth and value funds. (Growth funds invest in companies that are growing, while value funds invest in companies that are undervalued. This is either buying what is doing well or buying what is considered cheap. Both strategies work with one outperforming the other at different times. Most index funds give you both, but some specialize in one or the other.)
Having choices allows you to tune your retirement investing. The target-date retirement funds also allow you to put your retirement investing on autopilot if you wish. If your 401k choices only include high-cost funds that don’t really tell you in what sector of the market they invest, your plan stinks.
Want all the details on using Investing to grow financially Independent? Try The SmallIvy Book of Investing.
3. Your plan switches in and out of funds.
This really isn’t so much the plan itself, but the people setting up the plan. Sometimes the board who creates and manages the plan will change the funds available because some funds have not done well. Assuming the funds don’t have high fees or something, the reason they may not have done well is that the sector of the markets in which they invest may not have done well. For example, maybe you have a value index fund during a time when growth stocks are doing well, so the value fund returns 3% while the growth funds return 20%. The board may see this and get rid of the value fund, substituting another growth fund in its place.
This is exactly the wrong thing to do. Because growth stocks have done well, it means that they may have already gone up in price to the point that they are expensive. Conversely, value stocks may now be especially cheap. Think of going to the store and finding that strawberries have doubled in price, while grapes are selling for 80% of what they normally sell for. While you don’t know what strawberries and grapes are going to sell for next week, you can bet that over time strawberries will not go up in price as much as grapes will. The same is true for stocks. While the timing is difficult, you will not do as well buying stocks when they are expensive after a big run-up as you will if you buy them after a drop when they are cheap. If you find that your funds get dropped when they don’t do as well as other funds, other than due to the fact that the fees are high, your 401k plan may stink.
What to do if you have a stinky plan.
There is not that much you can do if you have a bad plan, but there are a few things. These are:
- Invest outside of your plan in an IRA.
You can open up an Individual Retirement Account (IRA) with any mutual fund company or brokerage firm. This will allow you to get the same tax-deferral that you get with a 401k plan. Inside an IRA, you can invest in almost anything. If you open an IRA with a mutual fund company, you will often be able to invest in their mutual funds without paying a fee when you buy or sell the funds. Tax laws may limit the amount you can put into an IRA if you have a retirement plan at work, but you may be able to put some into an IRA. You will also probably be able to put the full amount (currently $5500 per year) in an IRA for a non-working spouse even if you have a 401k plan at work.
2. Invest in a taxable account.
While not as good as an IRA, there is nothing from stopping you from investing for retirement in a taxable brokerage or mutual fund account. If you invest in index funds and hold them for long periods of time, you’ll still pay very little in taxes each year. While you may pay some taxes on capital gain distributions from the fund, as well as on dividend and interest payments, most of the time you’ll only see a big tax bill if you sell funds at a big profit. If you buy and hold, most of your money will be left to compound just like it would in an IRA or 401k. In fact, your tax bills at the end may be lower than you’ll see with a 401k since capital gains rates, which you’ll pay on profits from a taxable account, are usually substantially lower than standard income tax rates in the top brackets, which is what you’ll pay for large 401k distributions. You won’t see a tax break when you put the money into a taxable account, however, like you will when you put the money into an IRA or 401k.
You can also buy some individual stocks in a taxable account and not see a big tax bill (until you sell). You just need to hold them for long periods of time, like ten to twenty years, rather than buying and selling stocks for a quick profit. The good news is, you’ll do far better buying stocks for long periods than you’ll do trading. This is like a win-win. You can also reduce your taxes when you do sell by selling losing positions to offset gains in winning positions
3. Be sure you still get the company match.
If you do decide to us an IRA or invest in a taxable account, you’ll still want to put enough money into the 401k plan to get whatever matching funds the company provides. This is like getting a 100% or 50% return on your money right from the start. If you do this, but your 401k plan stinks, you can always roll whatever is in your 401k plan to an IRA when you leave the company.
Have a burning investing question you’d like answered? Please send to [email protected] or leave in a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
