The hidden costs of 401(k) plans: Rethinking America's retirement strategy

Many Americans rely on 401(k) plans to fund their retirement. The two most significant theoretical benefits of 401(k) plans are that they are "qualified plans" and that many firms provide an incentive for employees to save for retirement by "matching" employee contributions.

While 401(k) plans have been a staple of retirement savings for decades, it's important to understand their evolution and the changing landscape of retirement planning. Initially introduced in the 1980s, these plans were designed to supplement traditional pension plans. However, over time, they have largely replaced pensions as the primary retirement savings vehicle for many workers. This shift has placed a greater burden on individuals to manage their own retirement savings, leading to both opportunities and challenges for American workers.

However, while these advantages are frequently highlighted, 401(k) plans also have substantial disadvantages.

The Biggest Issue With 401(k) Plans

While there are numerous issues with 401(k) plans, space constraints prevent me from addressing them all. Their main issue is cost. BrightScope and the Investment Company Institute discovered that in 2021, the average overall 401(k) plan expense was 0.81% of assets. Furthermore, hidden costs can significantly increase that amount.

It's worth noting that the impact of these costs can be substantial over time. For example, a difference of just 0.5% in annual fees can result in tens of thousands of dollars less in retirement savings over a 30-year career. This compounding effect of fees is often overlooked by plan participants, who may not fully grasp the long-term implications of seemingly small percentage differences. Additionally, the complexity of fee structures in many 401(k) plans can make it challenging for the average employee to accurately assess the true cost of their retirement savings strategy.

With a $500,000 beginning value, a 401(k) might cost hundreds of thousands of dollars in fees over the course of decades. And that doesn't even include any hidden expenses that you won't notice.

You can conduct your own research on "hidden 401(k) fees," and you will undoubtedly be surprised by what you discover. Ted Benna, the "father of the 401(k)," stated that he "helped open the door for Wall Street to make even more money than they were already making." "That is one thing I regret."

There are tax implications, too.

To add insult to injury, depending on your tax level, over 25% of your 401(k) balance may not be yours. It belongs to Uncle Sam as future taxes. You're paying fees for money you owe the government. Allow me to repeat: you're paying fees on money owed to the government. Allow that to soak in for a few minutes.

Withdrawals from 401(k)s are taxed at the highest possible rate, regular income. And, if that wasn't enough, there's a chance taxes will be greater when you withdraw the money years later in retirement.

When you consider the fact that plan guidelines can restrict access to your money, investment options are limited, distribution flexibility is limited, and your account is vulnerable to market crashes, investing in a 401(k) may be more of a financial obligation than a benefit.

Despite these drawbacks, it's important to recognize that 401(k) plans can still play a valuable role in a diversified retirement strategy. For many workers, particularly those in lower tax brackets or early in their careers, the immediate tax benefits and employer matching contributions can outweigh the long-term costs. Furthermore, recent legislative changes, such as the SECURE Act, have aimed to improve 401(k) plans by expanding access and increasing flexibility. As with any financial decision, the key is to carefully evaluate your individual circumstances and consider how a 401(k) fits into your overall retirement plan.

Other voices express similar concerns.

If you've never heard of these difficulties, you could assume I'm insane or attempting to trick you. You are thinking that this cannot be real. Okay, it's not just me.

Stephen Gandel argues in the October 2009 issue of Time, "Why It's Time to Retire the 401(k)," "The ugly truth, though, is that the 401(k) is a lousy idea, a financial flop, a rotten repository for our retirement reserves."

The Fiscal Times ran an article titled "The Retirement Revolution That Failed: Why the 401(k) Isn't Working."

And in their book The Great 401(k) fraud, William Wolman and Anne Colamosca hit this doozy: "The 401(k) will turn out to be the greatest systemic financial hoax ever perpetrated on an unsuspecting public."

So, why are 401(k) plans being pushed on employees?

You may be wondering: If the 401(k) is so horrible, why are we all taught it's the best way to save for retirement? The answer is an old cliche: "Follow the money."

Your business promotes the 401(k) because it is a "employee benefit" that you pay for, allowing them to avoid paying for more expensive pensions.

Wall Street promotes the 401(k) because qualifying plans demand high fees, and Uncle Sam promotes it because withdrawals from 401(k)s are taxed in the highest tax bracket.

It's crucial to understand that the promotion of 401(k) plans is not solely driven by malicious intent. These plans do offer some genuine benefits, such as tax-deferred growth and the potential for employer matching contributions. However, the shift from defined benefit plans (pensions) to defined contribution plans (401(k)s) has also transferred much of the risk and responsibility of retirement planning from employers to employees. This change has coincided with broader economic trends, including increased job mobility and longer life expectancies, which have made traditional pension systems less sustainable for many companies.

What Are the Alternatives?

So, what would I recommend?

While the costs are high, the free employer match makes it advantageous to save money in a 401(k). I frequently advise folks to contribute up to the company match and invest the remainder of their money wisely. For example, if you contribute 10% and your company matches up to 5%, you could cut your contribution to 5% and invest the remainder in a lower-cost vehicle like a Roth IRA or regular IRA.

If you decide to withdraw money from your 401(k), do so as soon as you can. When you move employment or retire, you may withdraw funds from your 401(k). Far too many folks I speak with still have money in their 401(k) plan years after leaving their work. All those hefty fees are a waste of money.

Furthermore, a substantial number of plans enable "in-service" withdrawals when the employee reaches the age of 59 1/2. Please contact your plan administrator to determine if that option is accessible to you. After that, continue to contribute to the plan to receive the maximum employer match. Withdraw the balance again when the plan allows.

Remember that if you withdraw funds from your 401(k), you will have to pay income taxes on the amount removed. However, you can "roll over" your 401(k) to an IRA, which will be considered a "nontaxable event." You will not pay any taxes. However, when you take from your IRA, you will be required to pay income taxes.

As the retirement landscape continues to evolve, it's essential for individuals to stay informed and adaptable in their approach to retirement planning. While 401(k) plans have their drawbacks, they remain a significant part of the retirement savings ecosystem. The key is to use them strategically as part of a broader financial plan. This may involve combining 401(k) contributions with other savings vehicles, such as IRAs, Health Savings Accounts (HSAs), or taxable investment accounts. Additionally, as financial technology advances, new tools and platforms are emerging that can help individuals better manage their retirement savings, potentially mitigating some of the traditional drawbacks of 401(k) plans. Ultimately, the most effective retirement strategy will be one that is tailored to your individual needs, goals, and financial situation.