Classic Estate Planning advice to youngsters entering the workforce is that they should sign up for the employer’s 401(k) plan and begin saving money for retirement. It’s time to reconsider that advice. I’m not questioning the first part of the advice. Youngsters should begin saving as soon as they start earning money. The question is whether saving through a 401(k) is the best strategy for them.
You know the advantages of 401(k) contributions. Salary that is deferred into a 401(k) account is excluded from gross income for tax purposes. It’s invested in the account and grows tax deferred. The maximum deferred this year is $16,500 ($22,000 for workers age 50 and over. When the worker leaves an employer, the account can be maintained or rolled over to a new employer’s 401(k) or to an IRA.
It generally isn’t wise to turn down the opportunity to receive this money. It’s really part of compensation or can be viewed as a guaranteed investment return on the 401(k) deferrals. My advice is if the employer offers a meaningful matching contribution, an employee should participate in the 401(k) at least enough to receive the maximum match.
But there are disadvantages to a 401(k), and they are reasons to consider not participating beyond the employer match, or not participating at all when there is no match or a very modest one or when the plan has bad features.
The accumulated contributions and compounded returns are taxed as ordinary income when withdrawn. Particularly for a young worker who’s in a low tax bracket, tax rates are likely to be higher when withdrawals are made than they are now. Also, the process converts some tax-advantaged capital gains into higher-taxed ordinary income. In addition, distributions are required after age 70½, whether the owner wants them or not.
The really big reason to consider bypassing the 401(k) is the fees charged. Most people don’t even realize they’re paying fees on their 401(k)s, much less know how much those fees are, according to an AARP survey. There are several layers of fees on most 401(k) accounts, and they can mount to a tidy sum. The fees often are deducted directly from an account or the investment funds in the account without being clearly identified on account statements. So, an employee might never see the fees being imposed. Regulations are in the works to make the fees clearer, but they still won’t tell the full picture and most investors probably won’t read them or recognize the full impact.
High fees weren’t a big issue in the bull market of the 1980s and 1990s. But in a period of low and below-average investment returns, fees take away a high percentage of the account’s returns. Investors in 401(k) plans maintained by small employers pay an average of 1.9% in fees annually. Since that’s the average, a high percentage of folks are paying more than that. Youngsters should do the match before signing up for the 401(k). If the account earns 6% for a year, 1.9% in fees takes away almost a third of the returns.
I’m not recommending that everyone eschew the 401(k) in ther retiremetn and estate planning. A number of large companies have good 401(k)s. The employer picks up all or part of the fees. It also negotiates to ensure the investment offerings are high quality and have reasonable or low fees. When a youngster is working for such a firm, participating in the plan is a good idea. If he or she leaves the firm, the 401(k) balance can be left with the good plan or rolled over to an IRA.
But when there are high fees and poor investment choices, there are better saving alternatives. It might be better to contribute the maximum to an IRA (either a traditional IRA or Roth IRA) and save additional amounts in a taxable account. The initial tax breaks might be nonexistent or not as great, but over the long term avoiding a bad 401(k) plan will result in more after-tax, after-expense worth.
Here are the typical fees imposed on a 401(k) plan that can signifficantly affect the estate planning strategy. An employee should study the plan’s documents to determine which of these fees are paid by the employee or his account, and how much they are.
The firm that does the plan’s accounting, provides Internet access, issues account statements, and processes transactions receives this fee. The firm also files reports for the plan with the IRS and Department of Labor. The fee might be a percentage of the account value or a flat fee per account.
These go to the firm that has legal or physical custody of plan assets. It could be the same firm as the recordkeeper or it could be a separate trust company or other firm. This fee often is the lowest.
These fees go to the mutual funds or other money managers in which accounts are invested. There could be several fees here. There might be the usual investment management fee plus a 12b-1 fee to cover the money manager’s marketing expenses.
Some plans offer investment advice to the participants. This could come through a web site that provides investment advice after the employee completes an online questionnaire. Or the advice could be provided by a registered investment adviser who is available to meet with employees and make investment recommendations. Some advisers will make the investment choices and monitor them for the employees. When it’s web site advice, the fee probably is per account and might be paid by the employer. Personal advice usually is a percentage of the account’s value and subtracted from the account.
Sometimes these are included in the fees paid for recordkeeping, administration, custody, and trustee services. Other times they are paid separately. When the employer does not cover them, they’ll be deducted from each employee’s account, usually as a fixed dollar amount. The likely services include legal fees for preparing the plan documents and an audit of the plan.
A plan might have a number of a la carte fees for services that not every employee will use. There could be fees for taking loans or hardship distributions, rolling over some or all of the account to another plan or an IRA, terminating the account, setting up periodic distributions, dividing the account as part of a divorce, and other actions. There should be a list of these services and their fees available to an employee. Be alert for fees that charge you for leaving the plan.
When they enter the workforce, young adults should begin saving for retirement and start estate planning . But they shouldn’t automatically do this saving through the 401(k) plan. An employee needs to study the documents, determine all the potential fees that will be imposed on the account, and decide if the 401(k) is a good deal or if saving through another means is a better estate planning choice.
RW August 2011
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