There's no doubt a 401(k) is a great resource for saving and investing for retirement. It's a reason they're regarded as the best resource by many people. It's a 2-for-1: You can lower your taxable income and save money in the present, as well as put yourself in a position for a financially comfortable retirement.
Despite all its benefits, 401(k)s aren't with their downsides. Most notable is their fees, which can slide under the radar if you're not careful.
Image source: Getty Images.
The various types of 401(k) fees
Under the hood of your 401(k), some fees look low in theory but are expensive in practice. There are three main types of 401(k) fees:
- Administrative: These deal with the management and upkeep of your 401(k). They can include bookkeeping, accounting, customer service, or legal.
- Investment: These are called expense ratios, and are investment-specific and charged as a percentage of your invested total.
- Services: These are for individual services, such as administering loans, hardship withdrawals, or distribution processing.
Fees vary by plan and the services someone chooses but generally range from 0.5% to 2%. Although on paper that's only $5 to $20 per $1,000 invested, it can add up throughout a career -- especially as your balance grows.
For perspective, imagine $1,000 monthly investments into two accounts that average 8% annual returns over 25 years. Here's how those accounts would compare, based on annual fees.
| Annual Fees | Amount Paid in Fees | Value After 25 Years |
|---|---|---|
| 0.50% | $61,500 | $815,700 |
| 2.00% | $218,900 | $658,300 |
Data source: Author calculations, rounded to the nearest hundred.
Even a slight 1.5 percentage-point difference accounted for over $157,000 in fees paid over 25 years. For many people, that's at least two years' worth of retirement income just in fees.
The simple solution would seem to be just picking cheaper investments, but with a 401(k), your plan provider provides your investment choices. Generally, the options are your company's stock, target-date funds based on your projected retirement year, and various individual fund choices. If all the appropriate options for you charge high levels of fees, your best decision might be to limit your 401(k) savings -- which isn't an ideal situation.
More options mean more chances to avoid high fees
An alternative option would be using a Roth or traditional IRA, which operates similarly to regular brokerage accounts because you can invest in any individual stock or exchange-traded fund (ETF) you'd like. It could be Apple, Cathie Wood's ARK Innovation ETF, an S&P 500 fund, or whatever suits you. IRAs are like brokerage accounts with tax benefits.
Having the option to choose your own investments can mean sidestepping the expensive options provided by a 401(k). An S&P 500 ETF like the iShares Core S&P 500 ETF, for example, has an 0.03% expense ratio.
Using our above scenario, an 0.03% expense ratio over that 25-year span would only amount to $3,800 in fees, around $215,000 less than 2% annual fees.
IRAs have a relatively low annual contribution limit -- $6,500 or $7,500 if you're 50 or older in 2023 -- so let's see the difference in fees with $500 monthly contributions, averaging 8% annual returns over 25 years.
| Annual Fees | Amount Paid in Fees | Value After 25 Years |
|---|---|---|
| 0.03% | $1,900 | $436,700 |
| 0.50% | $30,800 | $407,800 |
| 2.00% | $109,500 | $329,100 |
Data source: Author calculations, rounded to the nearest hundred.
Even with the lower contributions, a seemingly slight difference in fees can easily add up to five to six figures.
Don't settle for one resource
Contributing enough to a 401(k) to early any matching contributions from your employer almost always makes sense. But before maxing out your 401(k), consider utilizing an IRA to take advantage of the plentiful, cheaper options like S&P 500 ETFs.
Roth IRAs allow you to contribute after-tax money and take tax-free withdrawals in retirement. They make sense for people who anticipate their tax brackets being higher in retirement than right now.
Contributions to a traditional IRA may be tax deductible, depending on your filing status and income. They make sense for people in their peak earning years who anticipate their tax brackets being lower in retirement.
You'll want to take full advantage of a 401(k) while using other available resources. Saving and investing for retirement should be a multi-angle approach.
