4 Signs You Have a Bad 401(k) Plan and What You Can Do About It

The wrong workplace retirement plan can limit your portfolio's growth. How does yours stack up?

Kailey Fralick
Kailey Fralick
Feb 16, 2019 at 6:00PM
Investment Planning

Most people think of a 401(k) as a smart place to invest their money, and it can be. But it can also be a poor choice if your 401(k) restricts your savings' growth by charging high fees or offering few investment products for you to choose from.

Before handing over your hard-earned cash, you need to evaluate your 401(k) plan thoroughly to make sure that it doesn't come with any unpleasant surprises. These four red flags can be an indication that your 401(k) is a poor vehicle for your retirement savings. If it turns out your 401(k) is a stinker, don't worry; We'll also give advice on how to save your retirement dollars, instead.

1. Few investment options

401(k)s usually have a limited number of investment options pre-selected by your employer. The average plan offers eight to 12 investment products, but some plans may only offer three. These are typically mutual funds, but some companies may also offer company stock and variable annuities. More investment choices are usually better because you have more freedom to decide how you want to invest your money and it is easier to tailor your portfolio to your needs. If you only have a few choices and none of them line up well with your investing goals, your retirement savings may not grow as quickly as you'd like.

Overwhelmed woman at work

Image source: Getty Images.

If your 401(k) only offers a handful of investment products, you can talk to your employer and request that they give you more options to choose from, but they are under no obligation to comply. You could also open an IRA instead of or in addition to your 401(k). IRAs offer a much wider variety of investment products, including stocks, bonds, mutual funds, exchange-traded funds, and more, so it's easy to build a custom portfolio that aligns with your goals and risk tolerance.

There are two types of IRAs: Roth and traditional. Traditional IRAs are tax-deferred, like 401(k)s, so any contributions will reduce your taxable income in the current year, but then you'll pay taxes on your distributions in retirement. While 401(k) contributions are taken out of your paycheck before being taxed, traditional IRA contributions are taxed in your paycheck, but then you write off these contributions when you file your taxes for the year. Tax-deferred accounts are best if you believe you'll be in a lower income tax bracket in retirement than you are today. Contributions to Roth accounts, on the other hand, do not lower your taxable income that year, but then you don't have to pay taxes on distributions in retirement. They're a better choice if you think you're in a lower income tax bracket now than you will be in retirement.  

It's worth noting that IRAs have a much lower contribution limit than 401(k)s -- $6,000 in 2019 for IRAs compared to $19,000 for 401(k)s ($7,000 and $25,000, respectively, for adults 50 and older). If you plan to make large contributions to your retirement accounts, it's still a good idea to use your 401(k), even if you don't like its investment choices. You can contribute to your IRA first to take advantage of the wider range of investment products and then put any extra in your 401(k) to take advantage of the tax-deferred growth.

2. High fees

All 401(k) plans charge fees to cover your account's investment and administrative costs. Many people don't realize this because they never receive a bill for the charges because the money is taken directly out of your 401(k) each year. You can figure out how much you're paying in 401(k) fees by reviewing your plan summary or by looking at the prospectus for your investment products.

The cost of your 401(k) will vary depending on what you've invested in, how much your assets are worth, and the company you work for. Mutual funds charge shareholders an annual fee known as an expense ratio. This is charged as a percentage of your assets, so the more money that you have invested in that particular asset, the more you will pay. Administrative fees cover things like recordkeeping and other legal services. Larger companies are usually able to offer more affordable 401(k) plans because the administrative costs are spread across more employees whereas in smaller companies, everyone has to shoulder a larger portion of the expense.

Never pay more than 1% of your account balance in 401(k) fees each year. For a $1 million portfolio, you'd be throwing away $10,000 each year. Some larger companies are able to offer fees below 1% of your assets per year, while some smaller companies are forced to charge upwards of 2% of your assets per year. This can cut into your profits, forcing you to work longer in order to save enough for retirement or leave your finances short at the end of your life.

If your 401(k) plan charges high fees, you may be better off saving in an IRA. These accounts usually have much lower fees -- often under 0.5% of your assets per year -- especially if you invest in lower-cost investment products, like index funds. These are mutual funds that passively track an index, eliminating the need for costly portfolio managers and analysts. You could also speak to your HR department about offering more low-fee investment options to help you reduce your 401(k) expenses.

The one time you may be better off sticking with your 401(k) even if it charges high fees is if your employer-matched contributions are enough to cover these costs. This way, you don't have to worry about fees eroding the value of your personal retirement contributions.

3. No employer match

It isn't a smart move to write off your employer's 401(k) plan just because they don't match your contributions. If it offers a nice array of low-fee investment products, it's still a great place to stash your retirement savings, especially because 401(k)s have a much higher annual contribution limit than IRAs.

But if your employer doesn't match your contributions and they have few investment options or charge high fees, you may be better off putting your money in an IRA instead. The fees are lower and you'll have a lot more investment options to choose from. If you max out your IRA and still want to set more money aside, then you can place it in your 401(k) to enjoy its tax advantages.

4. Long vesting period

If your employer does match your contributions, there will probably be a vesting schedule that determines when your employer-matched funds become yours to keep.

Some employers have a graded system where, for example, 25% of employer-matched funds are yours after one year, 50% after two years, and so on. Others may require you to work for the company for a certain number of years before you're eligible to keep any employer-contributed funds. And there are others that may not have a vesting period at all, allowing you to keep all employer contributions even if you quit after a few months.

A three- to four-year vesting period is common, but some companies may have longer or shorter periods than this. You can check with your HR department if you're not sure of your 401(k) plan's vesting period. Of course, the vesting period shouldn't matter too much if you plan to stay with the company for many years. But if you're thinking about quitting soon, a long vesting period could end up costing you some or all of your employer match. If these are your circumstances, evaluate the 401(k) based on its fees and investment products to decide if it's the best place for your money, ignoring the employer match.

A good 401(k) is a great place for your retirement savings, especially if you'd like to automate your contributions. While this is possible with an IRA as well, you must set up the payroll deduction yourself instead of your employer setting it up for you.

If your employer matches your 401(k) contributions and offers a good selection of low-cost investments, it's definitely worth putting as much of your savings there as you can afford. But if your plan has one or more of the red flags listed above, you may be better off opening an IRA instead.