Saving for retirement is essential to achieving long-term financial security, and the costs involved with investing represent one of the biggest obstacles to successful retirement planning. The fees investors pay might seem tiny because they're often expressed in one-hundredths of a percentage point, also known as basis points. However, they actually add up to a huge amount over the course of your lifetime. Let's look at what you need to do in order to translate those fees from basis points to your true investing cost.
How 401(k) plan investment choices come up with basis point fees
Most 401(k) plans invest in mutual funds, and the expense ratios that those funds report are based on their total expenses each year as a percentage of the net assets. So if a fund has $1 billion under management and incurs annual costs of $5 million, then its expense ratio will be 0.50%, or 50 basis points.
Those fees are then taken on a pro-rata basis from the investments of each shareholder in the fund. The same percentage is applied to each investor, and so the larger the amount you have invested in the fund, the bigger your actual expenses will be.
Calculating your personal 401(k) fee
In order to come up with your total annual 401(k) fees, go through the following steps:
- Find out the expense ratio in basis points for each fund you own within your 401(k). Bear in mind that different funds can have widely different expense ratios.
- Divide the amount you have invested in each individual fund by 10,000. Then multiply the result by the number of basis points in fees that fund charges. The answer will give you the fees for that fund.
- Add up the fees for all your funds to get an overall answer.
A quick example can show how this works. Say you have $50,000 in your 401(k), with $20,000 invested in a stock fund with fees of 75 basis points and $30,000 invested in a balanced fund with fees of 50 basis points.
Here's how you calculate the annual fee you're paying for the stock fund:
($20,000 / 10,000) x 75 = $150
And here's your annual fee for the balanced fund:
($30,000 / 10,000) x 50 = $150
Add the two figures up, and you're paying a total of $300 in annual fees.
As your retirement nest egg grows, your fees will grow as well. On a $500,000 account allocated the same way as the example above, your annual fee would be $3,000. Over time, fees can reduce your eventual savings by tens or even hundreds of thousands of dollars.
Basis point fees look very small, but over time, they can add up. Make sure you know exactly how much money you're paying in fees every year, and you'll understand the importance of minimizing your investing costs.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.