The Hidden Costs of 401(k) Plans

Written by Jason Simpkins
Posted May 6, 2014

There was a time when American workers could get pensions that would provide guaranteed income for retirement.

But those days are long gone.

Now, we're betting our retirement on the stock market through 401(k) plans.

That leaves us to navigate mountains of dense, unintelligible investment plans from investment firms that are really only interested in getting a cut of our savings.

This shift from traditional pensions threatens the retirement security of millions of Americans. Many don't contribute enough or allocate their contributions efficiently. Some drain their accounts by taking out loans or cashing out to meet costs.

And sometimes they simply lose their money through no fault of their own: Either the stock market crashes or plan providers employ hidden fees to take advantage of the people they're supposed to be protecting.

So it's important to know the ins-and-outs of 401(k) plans.

A good place to start is understanding the aforementioned fees...

Beware Transaction Fees

A new study found that the typical 401(k) fees erase $70,000 from the average worker's account over a four-decade career. To compensate for the higher fees, someone would have to work an extra three years before retiring.

The problem is particularly bad at smaller companies, where fees are typically higher.

Total management costs at companies with more than $1 billion in assets average about 0.35%. But for companies worth less than $50 million, fees average 1%.

That may not sound like a big deal, but in actuality it is.

Consider what would happen to a 25-year-old worker, earning the U.S. median income of $30,500, who puts 5% of his or her pay in a 401(k) account and whose employer chips in another 5%:

  • If the plan charged 0.25% in annual fees and the investment return averaged 6.8% a year, the account would equal $476,745 when the worker turned 67.
  • If the plan charged 1%, the account would reach only $405,454 – a $71,000 shortfall.
  • And if the plan charged 1.3% – common for 401 (k) plans at small companies – the account would reach $380,649, a $96,000 shortfall.

So check what fees your paying and do what you can to limit them.

Loans and Early Withdrawals

Of course, management fees aren't the only pitfall to watch out for.

You also have to be wary of borrowing from, or cashing out, your 401(k) plan. These are common practices in times of economic hardship. But they come at a high cost.

In addition to 20% in federal and state income tax, investors younger than 59 and a half who cash out typically have to pay a 10% early withdrawal penalty. That means cashing out $50,000 in 401(k) savings can leave as little as $35,000 in cash.

Taking out a 401(k) loan avoids these taxes and penalties but there's still a tremendous amount of liability.

You essentially have to pay yourself back, with interest. And since your investments will be liquidated to make the loan, you’ll miss out on gains if the market shoots up. Plus, if you lose your job some employers may require that you immediately pay back the loan.

None of this isn't to scare you, just to make you aware of the risks.

So be careful.

Fight on,

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Jason Simpkins

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Jason Simpkins is Assistant Managing Editor of the Outsider Club and Investment Director of The Wealth Warrior, a financial advisory focused on security companies and defense contractors. For more on Jason, check out his editor's page. 

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