I’m not a qualified financial planner, and this post doesn’t represent financial advice. But, like many in my shoes, I must decide how to invest money in my company’s 401k plan. Before I invest, I need to know if it’s wise to invest in the 401k. Here, I’ll share my opinion on what makes a good 401k, and what options to look for if you’re stuck with a bad one.
Some background on myself: my role at Atomic isn’t strictly financial or benefits-oriented. However, I manage our team of 30+ people in Ann Arbor and have given many talks over the years on personal finance and investing. I believe it’s important to share financial knowledge because it is so impactful on the options people have in their lives. I self-identify as a Boglehead. For those of you interested in learning more, recommend their wiki and the writings of authors such as JL Collins and William Bernstein.
What makes a 401k “good”?
In America, employees are stuck with the 401k their employer offers. That is until they leave the company and can take the money somewhere else via a rollover. “Good” is relative, but my criteria for evaluation of a “good” 401(k) is as follows:
Low Administrative Fees
Administrative Fees are what your 401k plan administrator charges to run your company’s 401k. They exist in addition to the individual fund fees (represented as fund expense ratios). Administrative fees vary and the lower, the better.
In 2019 Business Insider reported analysis from BrightScope that,
According to an analysis by BrightScope, large 401(k) plans with $100 million or more in assets typically charge less than 1% in annual fees. This is a generally competitive rate, and the biggest plans regularly charge under 0.50%.
As plans get smaller, fees go up. The BrightScope study found that small plans often charge between 1.5% and 2% per year, with many charging in excess of 2%.
There are many potential fees associated with a 401k plan, the only way to know what your specific plan fees are is to read the prospectus.
Qualitatively, I consider plan fees above 1% “really bad”. If you discover your plan has high fees, you should think carefully about how much and when to invest in your company’s 401k plan. See the section on what do to if your plan is bad, below.
Good Fund Options
Within a 401k are investment funds employees can choose to invest in. These funds have been selected by your plan sponsor. A good 401k plan should include investments that:
- Are low cost. Fund expense ratios should not exceed 1.0%. The best 401k plans contain index funds with expense ratios below 0.10%.
- Allow participants to create a diversified portfolio. Funds should exist for US and International stocks and bonds. Employees should be able to construct a diversified portfolio that matches their desired risk profile solely from options in the 401k, ideally with low-cost funds.
- Offer Target Date Fund options. Target Date funds are great for employees who want a reasonable option that is diversified and regularly rebalances itself to match a desired risk profile. Good 401k funds will default new employees into these funds.
A good 401k plan will have enough, but not too many options. Like a great restaurant limits menu options to the best available, 401k plans should think carefully about the set of funds that are offered to employees. Having too many options isn’t necessarily a good thing in a 401k plan.
When making selections, employees should read through each fund prospectus, paying close attention to the expense ratio. Take special note of those options that are index funds and consider incorporating those into their selected portfolio.
An Employer Match
An Employer Match is a matching contribution your employer makes to your 401k when you contribute money. It is “free money,” and if your plan offers one you should absolutely contribute enough to maximize the match. According to ocho.com, the average 401k employer match is a partial match of 50% of employee contributions up to 6% of salary (for a total of 3%).
The more match, the better.
Additional Features and Nice-to-Haves
Some other features a good 401k could have include support for rollovers into the 401k (often to support backdoor Roth IRA contributions), in-service distributions, early withdrawals or loans in the case of an emergency, and Roth 401(k) options. Again, consult your benefits information and plan prospectus to find out what is available to you.
What should you do if your plan isn’t good?
In a perfect world, you could talk to your manager and get in touch with your company’s benefits administrator or executive in HR and they would be open to improving things by changing the plan. In the real world, this isn’t often a realistic option.
Because 401k plans have such favorable tax benefits, even a bad plan can be worth investing in. (Important caveat: This depends on the fund and your personal tax situation). If you have a bad 401k plan, consider these basic actions:
- Contribute enough to get the employer match. It’s free money, and I’ve not seen a plan where this is a bad decision.
- After getting the employer match, max your Traditional or Roth IRA. IRAs are preferable to 401ks because you are not limited to a small set of fund options, and you can find a low-cost provider (Vanguard, Fidelity, etc.). Once your IRA is maxed, you may consider if further investment in your 401k plan makes sense given your situation.
- Find and invest in the lowest fee option in the 401k, provided it will fit into the asset allocation you’re targeting across your entire investment portfolio (e.g., including money invested outside of your company’s 401k). For example, sometimes a plan will have crappy options, but one decent S&P 500 index fund. In that scenario, you may decide to use your 401k exclusively for your large-cap U.S. stock allocation and look for better international or bond funds outside of the 401k (e.g., in a taxable or IRA account).
Additionally, if you’re interested in a deeper analysis of whether your 401k investing makes sense, I recommend the advice in the Bogleheads Wiki.
What About Your 401k Plan?
At Atomic Object, we have improved our 401k plan’s fund options and fund share class over time. We now offer a reasonable set of funds split evenly between index options from Vanguard and actively managed funds from American Funds. Atomic offers an employer match, a Roth 401k option, and — in my opinion — has reasonable administrative fees (but we can always do better). I’d be curious to hear your experiences with company 401ks and, anecdotally, what sorts of fees and options people are seeing in 2023.