Is Your 401(k) a Good One?

The 401(k) is a big deal in America. Some 55 million workers are currently contributing to plans that held, in aggregate, more than $5 trillion in assets as of the end of 2017, the Investment Company Institute says. Several additional trillions of dollars are sitting in IRA accounts after having been rolled over from 401(k) accounts -- typically when workers change jobs.

If you're saving for retirement through an employer-sponsored 401(k) account, you may reasonably be wondering, "Is my 401(k) good?" Odds are, it is -- if it offers matching funds, low fees, a promising menu of mutual funds, a short vesting schedule, auto-enrollment, and more.

Image source: Getty Images.

Here's a closer look at 401(k) accounts -- their power to support you in retirement, the features that make a good 401(k) plan good, and how to make the most of your account.

What is a 401(k)?

When saving for retirement, it's smart to make good use of tax-advantaged retirement accounts such as 401(k)s -- and IRAs, as well. There are traditional and Roth varieties of each. With a traditional 401(k) account or IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income shrinks to $65,000 for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is the tax bill postponed, but it's often reduced.

A Roth 401(k) or Roth IRA, on the other hand, has the potential to be much more powerful. You contribute post-tax money to a Roth IRA, so your taxable income isn't reduced at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.) Here's why the Roth accounts are a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- when it's yours tax-free.

One big plus for 401(k) plans is that they have much more generous contribution limits than IRAs (which only accept up to $6,500 in 2018). For 2018, you can contribute up to a whopping $18,500 to a 401(k) account, plus another $6,000 for those 50 or older, for a grand total of $24,500. Many people can't sock away $18,000 or $24,000 in their 401(k) each year, but aim high, because the more you save and invest, the more you'll have in later years, and your earliest invested dollars are your most powerful, with the most time to grow.

IRAs are generally accounts you set up for yourself via brokerages or other financial services companies, while 401(k) accounts (or 403(b) accounts, for those in certain industries) are set up for you at your workplace. With an IRA at a brokerage, you can invest your savings in just about any stock and any of hundreds or thousands of mutual funds, but 401(k)s offer more limited menus to choose from -- which can be fine.   

The amazing power of the 401(k)

With its generous contribution limits, the 401(k) account is a great way to build long-term wealth. The impressive table below shows how much you might amass over time:

Source: Author calculations. 

The numbers above are amazing and inspiring, but it takes determination and discipline to achieve them. Most people are not on track to get there, though their retirement savings accounts have been growing in value. Fidelity Investments -- which serves 26 million customers who had $6.8 trillion in total customer assets as of the end of 2017 -- has noted that thanks to contributions that have been increasing in size as well as a strong stock market recently, both IRA and 401(k) accounts hit record high average balances as of the end of 2017:

Source: Fidelity Investments. 

Fidelity offered even more encouraging words: Those customers who had been contributing to 401(k) accounts for 10 or 15 consecutive years had even bigger balances:

Source: Fidelity Investments. 

Image source: Getty Images.

What makes a good 401(k) plan good?

Here are the kinds of features you'll find in the best 401(k) plans -- see which ones are offered by your employer's plan:

• Matching funds: Roughly half of employers who offered their workers 401(k) plans also offered them matching funds, per Bureau of Labor Statistics data from 2015. That's a black mark, then, for half the plans out there. But it's a plus if your plan features matching funds, with your company matching your own contributions to your account, to a certain degree. The most common matching scheme is when a company matches 50% of a worker's contributions, up to 6% of salary -- effectively offering a maximum match of 3% of pay. (To illustrate that with dollars, if you earn $75,000 and contribute 6%, or $4,500, your employer will add another $2,250 -- that's $2,250 of free money, a guaranteed 50% return on your investment.) Matches have been rising recently, though, hitting a median of 4% in 2016, per a Vanguard report, up from 3.5% in 2014 and 3% in 2007. There are some companies with much bigger matches, though, so don't think that 4% is great -- some workers receive 6% to 10% from their companies, though such contributions are far from the norm.
  
  
• Continuous matching: If your plan offers generous matching, but only deposits its promised matching funds in your account once a year, that's not ideal, since you may no longer be working for the company then. For best results, you want your employer to be continually matching, with each paycheck. That will help your account's value grow more briskly, too.
  
  
• Low fees: The fees your 401(k) plan charges you make a huge difference to your ultimate investment results, yet more than a quarter of Americans are not aware of what they're being charged in their 401(k), per a TD Ameritrade survey. You may not be able to change your plan's fees, but if they're high, do let your human resources department know that you're not happy with the fees. One way to keep fees low is to favor index funds when you invest the money in your account, but even some index funds charge too much. If your S&P 500 index fund is charging you 0.70% or 1%, for example, know that many such funds charge 0.25% or less. Here's how powerful fees can be: The table below shows how annual $10,000 contributions would grow at an annual average of 8% vs. 7%. Over 30 years, you'd lose out on roughly $200,000 just because of a one-percentage-point difference in fees!

Source: Author calculations. 

• A promising menu of mutual funds: Mutual funds are funds filled with the pooled money of many investors that's then professionally managed. As the table above reminds us, you want to see good performers in the menu of investment options that your 401(k) plan offers you. The funds should not only have good track records, but also low fees. One of the best things to see is a variety of low-fee index funds that track various broad market indexes, such as the S&P 500, the whole U.S. market, the whole world market, or perhaps some regions, such as a broad Asia or Europe index fund -- because index funds outperform most managed funds over long periods and tend to sport lower fees, as well. They've been recommended by everyone from The Motley Fool to Warren Buffett . When you invest in a stock index fund, your results will track those of the underlying index, which is a solid way to build long-term wealth. It's also good if you're offered target-date or "life cycle" funds, which allocate your money across various stock and bond index funds according to when you aim to retire, adjusting the allocation (reducing your stock exposure and increasing your bond exposure) as you approach retirement.
  
  
• A short vesting schedule: Your employer might be exceedingly generous in the matching funds it grants you, but much depends on the vesting schedule -- i.e. when those dollars actually become yours. Per a recent Vanguard report, 45% of 401(k) plans studied had matching funds vest immediately, which is optimal. But about 30% of plans had a five- or six-year schedule. That's bad news for people who leave the company before their money vests.
  
  
• Auto-enrollment: The best 401(k) plans will enroll you automatically, without waiting for your "I need to save for my retirement!" epiphany to occur. (Roughly a quarter of plans recently did so.) Ideally, you'll also get to start participating as soon as you start work, and not three to six months later. Many auto-enrolling plans will start you off at a relatively low level of participation when you could be more aggressive. Be aware of how much of your income is going to your 401(k) and make sure the percentage is as high as you want it to be.
  
  
• Auto-escalation: Another great trait of a 401(k) plan is auto-escalation, where your contribution percentage is increased every year, often without your even noticing it. This can help you build wealth more quickly. About three-quarters of plans that enrolled workers automatically also featured auto-escalation. If your plan doesn't offer this feature, just aim to increase your saving percentage on your own.
  
  
• A Roth option: Increasingly, many employers are offering the option of a Roth 401(k) account, which accepts only taxed, not pre-tax, contributions. Give it serious consideration, as it offers the chance to withdraw money from your account in retirement tax-free. More than half of employers with retirement plans were recently offering a Roth 401(k) -- but your employer may not offer that option yet. If so, let your human resources department know that you'd like it to be offered.

You can look up ratings for many companies' 401(k) plans at brightscope.com -- which rates them on fees, among other things. Compare your company's plan with others, and let your company know if you'd like to see any changes.

Image source: Getty Images.

How to make the most of your 401(k) account

It's not good enough to have a good 401(k) plan -- you also need to make the most of it, taking smart steps and avoiding blunders. Here are some suggestions:

• Participate! One of the worst things you can do with a 401(k) account is not use it -- or underuse it.
  
  
• Max out employer matches: First off, be sure to at least contribute enough to your account to grab any available matching funds from your employer -- it's free money.
  
  
• Take it easy with your employer's stock: Many employers make it easy to invest in company stock with your 401(k) contributions -- and some will make their matching contributions in the form of company stock. There's a clear upside to being an investor in your employer, as it will likely be the company you know best. But even great companies can fall on prolonged hard times -- or can fail. And your employer already provides much, if not most, of your financial support. If you're depending on your employer for your income as well as relying on it for your retirement, you have a lot of eggs in that one basket. Try not to keep too much of your net worth in company stock -- perhaps not more than 10%, at most.
  
  
• Don't cash out your 401(k): Many people cash out their 401(k) account every time they change jobs, but it's generally a bad idea. Sure, you may have worked at a given company for only three years and may not have much in your account, but if you remove even $20,000 that could have kept growing for you for another 25 years, you could lose out on about $137,000 in retirement money (assuming an 8% average annual growth rate). When you leave a job, you can do well to roll over funds in your 401(k) into an IRA, where fees might be lower and investment options broader. Read up on the rules, though, lest you end up facing a fine for doing it wrong. Another option many have when closing out a 401(k) account is to convert that money into an annuity that will pay regular sums monthly in retirement. If the annuity is from a highly rated insurer, it's like buying almost-guaranteed income that can help you sleep better in retirement. Just be sure it's a fixed annuity and not a variable or indexed one, as those tend to be more problematic due to high fees and restrictive terms.
  
  
• Don't borrow from your account: Don't borrow from a 401(k) plan, either, unless it's an emergency and you really have no better option. That's another way of stealing from your financial future. Borrowing means removing dollars that could be working and growing for you -- and that may never be repaid if you run into more trouble. (Not repaying a 401(k) loan can result in penalties and taxes, too.)
  
  
• Be smart about beneficiaries: Be sure to designate one or more beneficiaries. Fail to do so, and the money may go to a party specified by a state formula and not to whom you want. Also, designate your account as POD or TOD -- payable or transferable on death -- and it will get to your beneficiaries more swiftly, generally avoiding probate. Review and update your beneficiaries, too, lest the money end up in hands you no longer favor decades later.

Don't assume that Social Security and whatever you have in the bank will support you in retirement. The average Social Security retirement benefit is only about $17,000 per year. Make the most of your 401(k) account, especially if it's tied to a very good 401(k) plan. Doing so can leave you with tens of thousands of dollars more in retirement -- if not hundreds of thousands of dollars more.