Investing 101: Top Five 401(k) Questions

Just about everyone who has ever asked me for investing advice has always inquired about their 401(k) plan and if they are doing everything right. With this in mind, I figured I would address the most commonly asked questions when it comes to navigating retirement with the help of your employer...

1) What exactly is a 401(k) plan?

By definition, a 401(k) plan is a qualified employer-established plan where eligible employees can make salary deferral (or reduction) contributions either on a post-tax or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis - meaning that when withdraws are ultimately taken, they will be taxed at that time.

2) What should I do if my employer offers a "matching" plan?

Not all employers with 401(k) plans offer a matching plan, but those that do typically match based on percentages. Employees typically contribute anywhere from 0% to 6% of their post-tax earnings to their retirement plan, and this simply means that whatever the employee contributes percentage-wise, the employer will also contribute. This is what a lot of financial advisers refer to as "free money" from your employer since they are doubling whatever contribution you make yourself. Typically an employer will have a cap on their matching, so my suggestion is to find out what the cap is and then contribute at least that much. 

3) If I leave my employer, what should be done about my employer-sponsored 401(k) plan?

Many people will walk away from their employer (by choice or not) and ignore their 401(k) thinking that they should just set it and forget it. This is not wise at all. In those years that your money is sitting in a 401(k) your employer no longer shells out the management fees for your fund. This means that money is taken out of your retirement each year to pay these fees. Over time, your entire account could be near depleted just in paying fees. So when you leave, make sure to roll over the entire amount of your 401(k) into a Rollover IRA with a brokerage bank (Charles Schwab, Fidelity, TD Ameritrade, etc.) and then invest the money for yourself in some index funds or ETFs. Don't leave your money sitting at an old employer for years. 

4) Is it better to chose "tax deferred" if that is an option?

Odds are good that by the time you retire, you will be in a much higher tax bracket than you are today. In which case, it makes sense to pay taxes on your retirement contributions today because in the long run you will pay less. Most 401(k)'s defer taxes anyway and few allow that you pay taxes today. This is why most people opt for a Roth IRA instead. However, if the "Roth" option is available, take it!

5) What about fees?

I used to think it was okay to participate in an employer’s 401(k) plan if it meant that they would match your contributions. In fact, this is how I was able to save so much money in my 4 years with AIG. However, in the long run that “free money” provided by the employer is really just a way to offset some of the management fees that will accrue over time and the taxes that you will ultimately have to pay when you withdraw the money at retirement. It would make you sick to know just how much money is wasted on fees and taxes in a 401(k) over the course of your retirement. In fact, a research report from Demos shows that 401(k) nest eggs end up nearly 30% LOWER over a lifetime of savings thanks to fees alone.

More research from Demos has shown that the fees charged by 401(k)’s and mutual funds are extremely excessive; far beyond any realistic prices used to actually mange the funds. Ultimately, financial firms have a bottom-line interest and will push the management fees as high as the market can possibly bear, which is in direct conflict with the need of the investor (i.e. YOU). These investment advisors do not have a legal, fiduciary responsibility to protect your money or your best interests, and while recent government regulations after Dodd-Frank have tried to get the SEC to impose these responsibilities, they still have yet to do it.