The 401(k) is a first-rate investment vehicle, but it can come with hidden costs. Too often, an employer-sponsored 401(k) plan can contain expenses, charges and other costs that are not obvious—or even visible—in the balance statement. Understanding these 401(k) fees is key, especially if you like to make changes in your account or need to borrow against it. A few percentage points here and there can really add up over time.
In addition to regular fees, you may incur additional costs if you decide to take a loan from your 401(k). Here are the factors you need to know.
The 3 Types of 401(k) Fees
Basically, there are three kinds of fees that your 401(k) plan will charge you: Plan Administration Fees, Asset-Based Fees and Service Fees.
Plan Administration Fees
Plan administration fees are charged in different amounts, depending on the arrangement worked out by the employer with the plan administrator (not surprisingly, smaller companies are less likely to get as good a deal as big corporations). These are typically paid on fixed quarterly schedule. Among them:
- Record-keeping and accounting fees include services such as monitoring employee-matching and profit-sharing contributions, keeping track of vesting schedules, and conducting audits as required by law.
- Custody and trustee service fees are paid to the custodian that actually holds the plan’s assets. All of those stock certificates have to be kept somewhere, right?
- Other administrative fees can include costs for participant education, customer services, and the plan’s website.
Asset-based 401(k) fees are related to the actual investments held in the plan. They’re charged by the mutual funds your plan invests in, and typically they’re deducted from the plan’s overall assets (which is why they’re hard to see on your statement). There are three primary types of asset-based fees:
- Management fees. These are essentially compensation for the services of the fund manager—the human who actively decides which stocks the funds will hold.
- Expense ratio. This is the total operating expenses a fund charges to investors. These vary a good bit, but they average 1%.
- Investment advisory fees. These are fees paid to the plan administrator or manager by an employer to advise on investment selection. These fees are in addition to the expense ratio fees.
These types of 401(k) fees are charged to a plan participant for the completion of specific service:
- Paperwork Fees. Some circumstances may require additional fees. For example, in the event of a divorce, the plan administrator may charge a fee to divide the couple’s assets.
- Loan Fees. If you are trying to borrow against your 401(k), the administrator may charge you a one-time loan administration fee.
Borrowing from Your 401(k)
Having a 401(k) gives you a source of cash if things get tight. The loan fee isn’t the only reason to be careful about taking a 401(k) loan: You are borrowing from your future. Carefully consider the following.
When to Borrow from Your 401(k)
A 401(k) loan should never be done lightly. But it might make sense if:
- You have an extremely serious and/or immediate need.
- You’re unable to obtain a loan from any other source on reasonable terms (you might have to crunch some numbers here, comparing costs and interest rates for the 401(k) loan and others).
- Your need is a short-term one. The faster you pay back your loan, the less damage you will do to your retirement savings.
How to Borrow from Your 401(k)
When you borrow from your own retirement savings, you are making a loan to yourself. You will still have to pay interest on that loan, at a rate set by your plan administrator. Most plans allow you to pay back the loan on a five-year amortization schedule with no prepayment penalty (so if you can do it more quickly, go for it).
Then there’s the IRS to consider. If you fail to pay back the loan principal, you will owe income tax on the amount you withdrew (because you got a tax break when you contributed it, remember?), plus a 10% early withdrawal penalty if you’re under age 59½. Ideally, you can set up automatic withdrawals to ensure that the loan is paid off with regular payments. Another idea is to have your employer automatically deposit a portion of your paycheck to back to the plan (this is done with after-tax dollars, though).
Advantages of a 401(k) Loan
- Instant approval. Hey, it’s your money, after all. There is no loan application, no credit check, and the debt won’t even be reported to a credit bureau.
- Flexibility. You can repay the loan on your own terms and at your own rate (provided you make good by the end of your schedule) without having to consider minimum payments, penalties for prepayment, or late payment fees.
- Minimal fees. It’s not quite free money, but it’s close. There is usually a loan origination charge or administration fee, but these aren’t usually that bad; certainly, they’re often less than fees charged by commercial lenders.
- Interest is paid to yourself. With conventional loans, you’re paying interest to the lender. But when you take funds from your 401(k), you are both the lender and the borrower. Any interest you pay will go back to your own account.
Drawbacks of a 401(k) Loan
- You stop contributing. By borrowing money from yourself, you are no longer saving money for retirement. Your repayments aren’t augmenting your nest egg, they’re merely making it whole again. And, unless you can repay the total ahead of schedule, you’ve lost out on five years of earnings opportunities and compounding interest.
- You are not earning tax-free interest. Yes, you are paying yourself interest, but your are doing so from your after tax-income. If you had not taken the loan, you would still be earning a return on your pre-tax savings and your continuing contributions.
- You may have to repay the whole thing at once. If you leave your job, whether voluntarily or involuntarily, your plan may require you immediately make good on the entire loan—or do so within a few months.
The Bottom Line
Investing in 401(k) plans provides a huge tax advantage compared to many other forms of savings. Nevertheless, these plans seem to be able to charge an endless variety of fees. While many do not appear significant, over time, 401(k) fees can drastically reduce your portfolio’s eventual rate of return.
Consider these figures: Let’s say you set aside $500 per month in your 401(k) plan for 30 years, and it generated an annual 8% return. You would end up with $745,179. But instead of actually earning 8%, your 401(k)’s hidden investment fees pull down your portfolio’s performance to 6.5% for the same 30-year period. Your nest egg drops to only $553,089. Those hidden fees cost you $192,090!
Go ahead and fund a 401(k), especially up to the amount covered by the company match, if there is one. But the next batch of your retirement-oriented savings should go into an investment where you can easily see—and control—your investment costs, like a Roth IRA (or a Traditional IRA if your income is too high to invest in a Roth).
Only when you’ve then maxed out your Roth, should you consider adding more to your 401(k) if you still have money left that you want to save in a tax-advantaged retirement plan. The current Roth and Traditional IRA limit is $5,500 per year ($6,500 if you’re 50 or older). The maximum employee contribution for 401(k)s is $18,000 per year. Do the math to figure out what works best for you.
By better understanding the fees in your plan—and the terms for borrowing against it—you can make the right decisions to ensure that you get all that you can out of your retirement savings accounts.