Dealing With a Bad 401(k)

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What should you do if your company’s 401(k) plan is no good?

Well, let’s back up. How do you know whether it’s good or bad? Generally, a good plan offers a wide variety of investments with low fees and a healthy company match. Let’s take them one by one.

Investments

There should be a variety of mutual funds focusing on stocks of big, small and foreign companies. There ought to be a good long-term bond fund, as well as a money-market fund for parking cash. Participants are probably best served by index-style funds rather than actively managed funds with higher fees.

These days, a good plan also has target-date or life-cycle funds that automatically move money from stocks to bonds as the investor gets older. These funds also have an often overlooked side benefit: They automatically adjust their holdings every year to keep the asset allocation on track, a chore many investors neglect or don’t know how to do.

A good plan does not put too much emphasis on the employer’s stock, which is often used for the company’s matching contributions. Although participants have the right to get out of employer stock, the fact that the company is using it indicates it is putting its own interests ahead of the employees’. Concentrating a lot of money in one stock is just too risky.

With a little sleuthing, you can find out how your plans funds do against the competition. Find your funds’ ticker symbols and look them up at Morningstar.com.

Match

In a good plan, the employer matches a healthy portion of the employee’s contributions. Some companies make a dollar-for-dollar match up to a maximum, but a 50-cent match for every dollar the employee contributes is common as well. The higher the maximum, the better. A limit of 3% of the employee’s income is common, but some companies go to 5% or 6%. A match in the form of employer stock is less desirable than one allowing the employee to choose the investment.

Fees

Fees on mutual funds in the plan should be as low as possible, which is why it’s important to have index funds. Many of those charge less than 0.2%, while many actively managed funds charge more than five times as much.

Participants should also beware of administrative fees charged on top of fund fees. These are described in the plan’s annual report, or Form 5500, according to Morningstar's Christine Benz. She writes that it’s a red flag if administrative costs exceed 0.5% a year. Administrative fees are more common at smaller companies.

Benz says young workers can benefit from the option to make Roth 401(k) investments. A Roth feature does not provide an upfront tax deduction on contributions, but withdrawals in retirement are tax free. This is a good option for people who are in low tax brackets when they contribute but are likely to be in high brackets when they withdraw.

Now, what if your plan isn’t very good? Despite that, it almost certainly makes sense to invest at least enough to get the firm’s maximum match. Otherwise, it’s like turning down a raise.

Because of the tax deduction on contributions, it will probably make sense to contribute as much as you can afford to even if fees are on the high side. Of course, if you really think the funds would do poorly relative to competitors, it could make sense to invest in an ordinary taxable fund instead of the 401(k).

In the taxable fund, you won’t get a deduction on contributions, but you can avoid heavy annual taxes if you buy and hold funds that get most of their returns through long-term capital gains. Also, under current rules, long-term gains are taxed at a maximum of 15%, while withdrawals from 401(k)s (except for Roths) are taxed as income, at rates as high as 35%.

That may be enough to tip the balance in favor of a taxable investment if the 401(k) is really sub-par, especially if you are in a low tax bracket, which makes the 401(k) deduction less valuable.

Keep in mind, though, that when you leave the company you’ll have the right to roll your 401(k) into an IRA, which would give you unlimited investment options. So, if you don’t expect to stay with the firm very long, you could put money into its lousy 401(k), get the tax deduction, then switch to better investments after you leave.

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