Should I Still Contribute to a Bad 401(k) Plan?

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Along with other factors, new fee disclosure requirements for 401(k) plans have brought a lot of attention recently on “bad” 401(k) plans. These are plans with little or no employer match, higher-than-average fees, and/or limited investment choices.

I’ve gotten a few questions from readers who wonder if they should stop contributed to their subpar plans completely? As with most things, the answer depends. But here are some factors that I’d consider first.

Can You Save Better Elsewhere?
Depending on your situation, it may be better to put money away in other tax-advantaged vehicles like a Traditional or Roth IRA instead of your 401k/403b/similar plan. If you plan on socking away $5,000 a year, that is under the IRA annual contribution limits. Alternatively, if you have self-employment income you can look into a SEP-IRA, SIMPLE IRA, or Self-Employed 401k plan where you can choose the custodian.

Bad 401(k) Now, Awesome Rollover IRA Later?
According to the Bureau of Labor Statistics, the median employee tenure is less than 5 years. Even workers in “management, professional, and related occupations” had median tenures of 5.5 years. In other words, these days people don’t stay in their jobs very long. (Of course, some people may stay in their jobs for 30 years.)

When you switch jobs, you’re free from the bonds of your crappy 401k plan and can roll it over to a new provider with low fees and great investment options. Very few plans are so bad that you wouldn’t endure five years of mediocrity in exchange for 20-50+ years of precious tax advantages.

401(k) Investment Fees Are Trending Downward
Total plan costs for 401ks have dropped over time, albeit slowly:

According to the 13th edition of the 401k Averages Book, small plan costs fell from 1.47 percent to 1.46 percent in 2012, while large plan costs fell from 1.08 percent to 1.03 percent. Expenses for small plans were between 0.38 percent and 1.97 percent, while large plan expenses ranged from 0.28 percent to 1.41 percent.

In terms of mutual fund expenses, these have also been dropping per this ICI study:

In 1998, 401(k) plan participants incurred expenses of 0.74 percent of the 401(k) assets they held in equity funds. By 2012, that had fallen to 0.63 percent, a 15 percent decline. The expenses 401(k) plan participants incurred for investing in hybrid and bond funds have fallen even more, by 19 percent and 23 percent, respectively, from 1998 to 2012.

Do The Best You Can With What You’ve Got
As part of this gradual improvement, most plans have added at least one lower-cost index fund option. For a while, the only decent option my 401k plan was an S&P 500 index fund with a 0.30% expense ratio. Sure, that’s three times higher than what I could have gotten on the open market from Vanguard/iShares/Schwab, but it was good enough especially given the 3% employer match. I would just use my other savings in IRAs and Solo 401ks to buy the other asset classes I wanted.

Dealing with Small Employer Plans
At least in my experience, the worst plans seem to be from smaller employers. This is because with large groups of employees, the juggernauts like Vanguard and Fidelity can make enough money from the billion-dollar balances though mutual fund fees that they can cover all the administrative things like legal compliance and mailing out statements. Smaller providers need to get the money from other sources, and often that means sucking it out of the employees via higher fees and revenue-sharing agreements with expensive actively-managed funds.

If it’s a small plan, then hopefully you can influence the person who choses the plan provider. If you’re just a worker bee, then hopefully in several years you’ll either be somewhere else (rollover!) or you’ll be promoted to management where you do have a say :). There are an increasing number of providers that specifically target small employers and also have reasonable fees, such as Sharebuilder 401k.

In-service Withdrawal
I see this one mentioned a lot, but I’ve yet to meet anyone with a plan that actually allows it. If your plan documents allow you to take an “in-service withdrawal”, then you can roll over your 401k balance into an outside custodian while maintaining your employment. If only this feature was required to be included in all plans…

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  1. Just a small note, the IRA limit is now actually $5500 in 2013.

  2. Thomas | Your Daily Finance says

    Personally I would still contribute to the bad plan. If you are getting the match and able to max out your 401k I would take a chance. Besides what is considered a BAD plan. Some people think its a bad plan because they are not making money right away. You may not like the returns but you could be getting a steal on the shares you are buying now remember 401k’s are for the long run. You don’t want to be buying everything when the prices are high. Dollar cost average over time and you should be good or maybe you are just picking bad funds. Get help is want I would say.

  3. I work for a small business owner who fancies himself an entrepreneur but is completely irresponsible with our 401k plan. I won’t go into the details, but I stopped contributing to the plan a couple of years ago and now just put as much as possible into my own IRA. I don’t think complaining to the boss will accomplish anything other than getting me fired.

  4. I was looking at my account and found all of them have expense ratio between 1.2 to 1.4 percent and there is no employer match. I’m still putting some amount there to gain tax benefits. Not sure if I should continue. What you guys suggest

  5. Stuart Weissman says

    Erik. You better be maxing out your ROTH IRA first. As for the tax benefit, you would need to do the math to see if your return in a taxable account would be greater (even after paying the Man) than your tax free return in your 401k. Keep in mind, if it’s not a ROTH 401K (they are rare), you will be paying taxes upon your withdrawal. I’m guessing you could probably do better outside of the 401K, but that’s for you to determine.

  6. I am in this situation myself. I started for a contract company in April and their 401k options are expensive with no match. I chose a S&P 500 index fund with .25% expense ratio for all my contributions to try to get the money into a tax advantaged account. I will roll it into my IRA once employment ends. I am already maxing my Roth IRA too, so it is there or a taxable account.

  7. I work at a small company with a 401k plan that allows in-service withdrawals.

    However, we also have an HR/accounting head who listened to suggestions on picking a plan long ago, so we have a great one that allows investment in just about anything via a Schwab account. Company is too small to do any contribution matching, but having such a great plan makes up for it.

  8. Roth IRA is the way to go if there is no employer match… One benefit of Roth IRA is that you can withdraw the principles without penalty after five years. That gives you flexibility down the road.

    My strategy is to contribute enough to get the maximum employer match, then I max out my Roth IRA (the limit is now $5500)…

  9. chris powell says

    If the 401k plan offers a matching contribution or a “safe harbor” contribution the person who opts to do their own IRA instead is walking away from free money from the employer.

    Not everyone can have a Roth IRA…high paid taxpayers are disqualified from having a Roth IRA, but there are no income limitations for a Roth 401k.

    It’s been my experience that no matter what–the 401k is a better deal because of the ease of saving via payroll deduction. IRAs on the other hand require self-discipline and overcoming inertia which is a real problem and the reason that 401k plans are such a success and IRA’s are not.

  10. joekammal says

    Is there a way you could take our money in invest it in 401k on our behalf as the manager using the principles you’ve stuck to over the years described on the blog. I guess you would need a CFP license.

  11. Erik,

    I am in the same boat as yours. I contribute to Roth IRA first and then contribute 17500 to my 401K plan which has expense ration of 1.0+. Even though it is high, I do for tax benefit and accumilating money for retirmement

    It would be great to hear what Jonathan would say…


  12. Well I do have Roth 401K and pretax 401k options, but only 18 funds are available in them and most of them have 1.2%+ expense ratio. Only index funds are around 1%. Should it be better idea to go with Roth 401k?
    Currently I’m putting everything in pretax-401K and will start maxing out next year. What is the difference between ROTH IRA and ROTH 401k. Wikipedia is like 4 pages worth of read.

    Thanks for all the help.

  13. The question whether to continue contributing in a bad 401k in my opinion is spinning around one point – employer match. If there is no match or too bad to be true, I think there is no reason staying in such 401k. In many occasions 401k have limited investing opportunities and in many occasions these are quite expensive mutual funds and I believe I can do better and cheaper elsewhere. So if there is no match move on. One thing which may make things difficult is that in many cases your contributions are directly from your paycheck before you even get your hands on it. If you do not have the discipline saving elsewhere on your own, you may end up without any savings (as most Americans are).

  14. @David – You are correct for 2013 (for those not 50+ who get $6,500). I was just using $5k as an example number.

    @Erik – Your plan does sound “bad”, but if you think you’ll leave soon then it is worth it to lock in that tax-advantaged status on those funds.

    @Geoff – Sounds like what I’d do.

    @Jay – That’s cool, it makes sense that a small business would do that because it is easy to allow that although most providers with cookie-cutter plans wouldn’t voluntarily as they want you commited. Schwab PCRA account?

  15. @joekammal – Ha, thanks but I prefer to keep my life simple and I don’t want the stress of managing other people’s retirement money. 🙂

    @Martin – I would disagree in making that rule, as even without employer match the opportunity to set aside money that can grow tax-deferred is still a great advantage over a taxable account. The specific math will depend on age, investment choices, tax bracket, etc but would take a pretty bad plan AND a long period in that plan to make it worse than taxable, especially if you’re investing in any bonds that would otherwise be taxed like ordinary interest income.

  16. Jonathan, I can do tax deferred IRA rather than locking money in a bad 401k. The only benefit in that case I would see is the amount allowed to contribute into 401k and IRA, but that’s it.

  17. Yes, I’m talking about above the IRA contribution limits. Only saving up to the IRA limits will make it difficult to achieve a comfortable retirement unless you have a decent pension as well.

  18. Chris Cavalier says

    I personally do not have a 401k plan due to its many flaws, especially the hidden fees. Instead I have taken it upon myself to build my own portfolio of businesses and investments that will provide me with income for retirement.

  19. I think some people greatly underestimate the benefits of deferring tax now with a 401k. The key thing often missed is that deductions come off the top (your highest bracket) but future withdrawals start from a lower bracket and work up. People often say if tax rates ‘stay the same’ there is no advantage to defer tax now or later, but that is not always true.

    As an example I have no match in my 401k and so-so fund selection, but I’m contributing the max before even thinking about the Roth and here’s why. At my income those deductions all fall within the 25% tax bracket and the 5% child tax credit phase-out, so I defer paying 30% tax. However if I retired only needing 75% of my current income, the 401k withdrawals ould be largely in the 15% bracket.

  20. @Jonathan, I agree, but in that case I would still prefer a taxable account over a bad 401k. If I will be investing in a commission free investments and not selling, I will be better off than with a bad 401k. For example my 401k offers a limited number of mutual funds, all with expense ratio over 2% (!!) some of them even over 2.5%. At the end of the savings cycle 401k withdrawals will be taxable (the same as in a taxable account), so if I start purchasing commission free ETFs (with an expense ratio at 0.2%) and never sell, what is the difference between 401k and taxable account? If I receive dividends I will have to pay tax on them now instead of 30 years later, but it still will be better off than paying 2.5% to mutual funds and have no employer match. Don’t you think so?

  21. Cam, I do not agree with you. When you retire, many of the deductions you have now will be unavailable to you 30 years from now, like child credit, mortgage deductions, all you will have available will be your personal credit. That’s it., so you may be saving it now when contributing to 401k, but pay it greatly later.

  22. YearZero says

    If any of you work for small employers with bad plans (mine was terrible….1.5% asset management free with fund expense ratios averaging 1.2%) lobby your employers to look at Employee Fiduciary

    Their fees are rock bottom low and they offer all Vanguard funds. I did not contribute to my own plan for more than two years but recently convinced our office manager to switch. The fees our company plays, also, are extremely low, lowest around.

    If anyone is playing, like our office was, more than 2.5% before even investing, you are getting robbed, should not contribute and should lobby for change in your place of employment.

  23. Dividend investing Martin,

    No child tax credit or mortgage deduction in retirement also means no kids to support and no mortgage payment – if you need less income you may have less net taxable income than today even without the deductions. But my point is that 401k contributions today defer tax in your highest bracket but withdrawals (if your primary source of retirement income) span lower brackets. I’m sure you are aware how brackets work but if you are married and make say 100k in taxable income this year, the first $72k is taxed at 15% or less, and every dollar above that 25%. You save 25% tax on every dollar contributed to your 401k.

    So using numbers above I contribute $1 to my 401k now and don’t pay the 25 cents tax on it. It doubles to $2. I only need 75% income in retirement and my withdrawals are taxed at 15% which nets $1.70 from the $2.

    Lets say instead I paid my 25% tax on the dollar and put the net 75 cents in my roth, it also doubles and I get $1.50 in retirement. Big difference from the $1.70 I would have got out of the 401k. Now convert that to real ending balances like 1.7 million vs 1.5 million and you see a real difference. Granted you need to look at other factors (like the fund fees) and we have no idea if or how rates will change, but you can only go with what you know today.

  24. YearZero is right.
    Employee Fiduciary is the best place for small business 401k plan.

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