Common 401k Problems and Their Financial Impact

A 401(k) is a defined contribution plan that allows employees to contribute a portion of their wages to an individual account. The funds in the account are then invested with the goal of growing the balance to provide income during retirement. Employee contributions are pre-tax, which lowers current taxable income. This tax-deferred status means that taxes are not paid on the contributions or their investment earnings until the money is withdrawn. Many employers also offer to match a certain percentage of an employee’s contributions, providing an additional incentive to save.

Issues with Plan Fees and Investment Options

Various fees can reduce a 401(k)’s investment returns over time. One common type is the administrative or recordkeeping fee, which covers the costs of managing the plan, including accounting and customer support. These can be charged as a flat annual fee per participant or as a percentage of the total assets in the plan.

Another layer of cost comes from investment fees, expressed as an expense ratio. The expense ratio represents the annual cost of operating a mutual fund and is shown as a percentage of the assets invested in that fund. For example, a 1% expense ratio means that for every $10,000 invested, $100 is paid in fees each year. These fees are taken directly from the fund’s returns, so they diminish the investment’s performance.

Individual service fees are a third category, charged for specific actions like taking out a loan, processing a rollover, or executing a qualified domestic relations order (QDRO). Participants can find a detailed breakdown of charges in documents provided by their plan administrator.

Beyond fees, the quality and variety of investment options can be a problem. Some plans provide a limited menu of funds, restricting a participant’s ability to build a well-diversified portfolio. A lack of choice might mean there are no dedicated international stock funds or certain types of bond funds, forcing savers into asset classes that may not align with their goals.

The performance of the available funds is another concern. A plan might offer funds that consistently underperform their market benchmarks. These underperforming funds may also carry high expense ratios, creating a dual drag on retirement savings and hindering an account’s growth potential.

Contribution and Employer Match Complications

Employer matching contributions and their associated vesting schedules can create complications. Vesting determines when an employee has full ownership of the employer’s contributions. Plans often use either a cliff vesting schedule, where an employee becomes 100% vested after a specific period like three years, or a graded vesting schedule, where ownership increases incrementally over several years. An employee who leaves their job before becoming fully vested will forfeit some or all of the matching funds provided by the employer.

Failing to contribute enough to receive the full employer match has direct financial consequences. Many employers offer a match up to a certain percentage of an employee’s salary, such as a dollar-for-dollar match on the first 3% of contributions. An employee who contributes less than the maximum matched amount is declining a guaranteed return on their investment, which can result in a significantly smaller retirement account.

Contribution limits set by the Internal Revenue Service (IRS) can also lead to issues. The IRS sets an annual limit on how much an employee can contribute to their 401(k). If an employee contributes more than this limit and the excess is not withdrawn by the tax filing deadline, it is subject to double taxation. This occurs because it is taxed in the year it was contributed and again when it is eventually withdrawn. The process to fix this involves removing the excess amount plus any earnings it generated.

Difficulties with Loans and Early Withdrawals

Withdrawing money from a 401(k) before age 59½ can introduce financial difficulties. An early withdrawal triggers a 10% penalty from the IRS, in addition to ordinary income taxes on the distributed amount. This means a person in the 22% federal tax bracket could lose 32% or more of their withdrawal to taxes and penalties, eroding their savings. While certain exceptions for hardship exist, they are narrowly defined, and the withdrawn funds are still subject to income tax.

Taking a loan from a 401(k) avoids the immediate 10% penalty but carries other financial risks. One issue is the potential for double taxation. Loan repayments are made with after-tax dollars, so the money is taxed before it goes back into the 401(k), and then it is taxed again as ordinary income when withdrawn in retirement.

Another drawback of a 401(k) loan is the opportunity cost of taking money out of the market. The borrowed funds are no longer invested and miss out on any potential compound growth.

A complication arises if the employee leaves their job with an outstanding loan. The deadline to repay the loan is the due date for their federal income tax return for that year. If the loan is not repaid by this deadline, the entire unpaid balance is treated as a taxable distribution, subject to both income taxes and the 10% early withdrawal penalty.

Handling an Old 401k After a Job Change

After leaving a job, an individual has several choices for handling their old 401(k), each with potential issues.

• Leave the funds in the former employer’s plan. The primary issue here is that the account remains subject to the old plan’s rules, which may include high administrative fees or a limited selection of poor-performing investment options. This can lead to years of subpar growth.
• Roll the balance into a new employer’s 401(k) plan. While this consolidates retirement assets, the new plan could have even higher fees or a more restrictive set of investment choices. It is important to compare the fee structures and fund lineups of both plans before initiating a transfer.
• Roll the funds over to an Individual Retirement Account (IRA). This option offers a much wider range of investment choices and greater control. The challenge lies in selecting the right IRA provider and investments, which requires careful consideration of account fees and portfolio diversification.
• Cash out the 401(k). This action is treated as an early withdrawal, subjecting the entire amount to ordinary income taxes plus the 10% penalty if under age 59½. This depletes current savings and forfeits all future tax-deferred growth on that money, representing a setback to long-term retirement security.