In the United States many employers
offer a 401k plan as a benefit to employees.
We are assuming that you are already enrolled in a 401k plan, and
contributing at least the minimum amount needed to get the full amount of any
employer match (if not, check out the New Investors
link on the sidebar).
But with limited investment choices and high
fees typically associated with 401k plans, should you be contributing more than
what it takes to get the maximum match from your employer?
It depends on how much you plan on investing.
After contributing the minimum
percentage needed to get the full employer match in the 401k, the next step is
to contribute to a Traditional or Roth IRA, up to the maximum allowed. Both 401ks and IRAs have tax advantages, but
the difference is you can generally pay much less in fees with an IRA. We wouldn’t recommend contributing more than
the minimum amount needed to get the full employer match in the 401k unless you
will be maxing out your IRA for the year, because the fees really add up over
time. For example, if you contribute
$5500 a year to a 401k and have a 10% return each year for 20 years (with
additional 1% in “expense ratio” fees), you will have paid over $38,000 more in
fees compared to an IRA with the same return over the same time period (assuming
0.04% in fees). Using the same example,
but over a 40 year period, the fees will add up to $500,000 (the balance of the
IRA would be $2.4 million vs. $1.85 million for the 401k). Since 401k plans vary, it’s worth looking at
the actual investments available in your plan and the fees associated with them. You can open your favorite spreadsheet
program and calculate the fees that you could be paying based on your own circumstances
(fee % in your 401k investments, number of years until retirement, amount
if you are maxing out your IRA for the year, should you contribute any
additional money to a 401k or just open a separate brokerage account to avoid
the fees? The tax advantage of a 401k
needs to be considered. Using the 25%
tax bracket as an example, if you contribute $18,000 to a 401k, it’s like only spending $13,500 of your money due to the
tax savings (and $4,500 of the “government’s money”). So for the same net cost, you can put $18,000
into a 401k or $13,500 into a separate brokerage account. Assuming a 1% fee for the 401k and otherwise
the same performance of the investments, you will still come out significantly
ahead with the 401k over a brokerage account.
However if the 401k investments available to you are not so good, you
can be looking at a 2% or greater difference due to worse performance and high
fees. In that case, the brokerage
account would be better after around 25 years (using 10% returns for the
brokerage vs. 8% for the IRA). Since
we’re talking about potentially hundreds of thousands of dollars difference, it
really is worth spending some time to perform your own calculations based on
your own circumstances.