With traditional pensions practically a thing of the past in the private industry, 401k plans have become the most common tax-deferred way to save and I would guess that many of you currently have a 401k. I'd also be willing to bet that some of you have 401ks at old employers. Because people are often unsure of what to do with these savings, we are frequently asked if it is a good idea to leave a 401k account with a previous employer. Our answer is always the same; No.
A 401k is a great savings vehicle while you are employed, especially if your employer matches even some of your contributions. Even without a match, saving into a 401k has substantial tax benefits since you are allowed to contribute up to $16,500 pre-tax ($22,000 if you are over 50). But 401ks are not perfect. They have several disadvantages, two of which are fairly significant: higher fees and limited investment choices. When you change jobs, an IRA becomes a much better alternative.
401k fees have received a lot of scrutiny over the years due to lack of transparency. Since 2007, the U.S. Department of Labor has been putting together a set of regulations that require 401k plan sponsors to better disclose information regarding the plan. A big part of this disclosure involves the plan fees and expenses. Up until now, it has been almost impossible for participants to understand how much they have been paying to participate in their 401k plans. These new rules are meant to improve the quality of 401k plans and make them more consistent from one employer to another. Unfortunately, they don't apply to 403b and 457 plans even though they suffer from the same shortcomings. These regulations were supposed to take effect this July, but have been pushed back to April 1st, 2012, mostly due to service providers arguing that it is too much work to make the changes. This is all but certain the final deadline.
Interestingly, this lack of transparency has meant that not only have many 401k participants not been aware of all the fees associated with their plan, but in some cases, the employer has not been aware either. This makes it difficult for the employer to select the best plan for its employees. Once the new regulations are in place, there will be a lot more disclosure from the plan sponsor to the employer and from the employer to the participant. Those employers who have been lax on choosing the best plan for their participants will now be forced to be more prudent in their selection since employees will be able to see every fee they are charged. Plan providers who have been overcharging for their services will be exposed and either pushed out by competition or forced to clean up their act. We view these new regulations as a much needed change in the 401k industry.
401k service providers have long gotten away with bundling fees which makes it difficult to identify how expensive a 401k plan is and what exactly the fees are paying for. The two most common categories of 401k plan fees are plan administration fees and investment fees. Administrative fees include fees associated with recordkeeping, accounting and legal fees involved with the day to day operations of the plan. In some plans, the administrative expenses are covered by investment fees and deducted from investment returns. Otherwise these expenses are either paid by the employer or charged directly against plan assets. Large employers often pick up the tab on expenses, but many smaller employers can't afford to do that. Another type of fee that participants may encounter is individual service fees, but these are pretty uncommon and are associated with optional features such as plan loans.
By far the largest component of 401k fees is investment fees. Investment management fees are generally stated as a percentage of the amount invested in each particular fund. There may also be sales charges associated with the buying and selling of shares. Some mutual funds have sales charges known as front-end or back-end load charges which are assessed either up front when you invest in a fund or when you sell the shares. One type of mutual fund fee expected to receive serious scrutiny is 12b-1 fees. These are ongoing fees paid out of fund assets to cover commissions to brokers.
Every 401k plan is different and so are the types and amounts of fees. While as an employee you don't have direct control over which plan your employer chooses, come April you will at least have a much clearer picture of what expenses you are paying. Armed with knowledge, employees who think they are paying an unreasonable amount in fees will be able to approach their employers and ask for some lower cost alternatives. Hopefully employers will use this as an opportunity to make sure that the plan they have in place is in the best interest of the employees. I don't think they want to get caught fielding complaints from unsatisfied employees.
While these new regulations are sure to improve 401k plans, an IRA held at a brokerage firm is still a superior long term alternative. Once you have left an employer, you are eligible to roll over your 401k into an IRA without incurring any taxes. If you have changed jobs over your career multiple times, you can roll all of these 401ks into a single IRA consolidating your assets and making them easier to keep up with. But perhaps most importantly, your investment choices are infinitely greater with an IRA than the handful you have to choose from in a 401k plan.
In conclusion, I want to reiterate the point that 401k plans are a great savings vehicle for employees. But there is definitely room for improvement and I am glad the Department of Labor's regulations are finally being put into place. Transparency is extremely important when it comes to the cost of services, especially with one's retirement on the line.
