Help, My 401(k) Stinks!

Updated on February 1, 2008.

LIKE A TYPICAL HANDS-ON investor, 43-year-old Max Richardson of Charleston, S.C., recently logged into his 401(k) account to redistribute some of his portfolio holdings. The goal? To shift assets out of the aggressive funds he was currently holding and into index funds instead.

Richardson was blown away by how much the move would cost him. To invest in the low-cost Vanguard funds offered in his plan, the plan provider would hit him with a 2.69% annual asset-management fee. Looking deeper into his plan's fee structure, he discovered that his 401(k) provider charged additional fees (beyond the fund's expense ratio) on all mutual funds, ranging from 1.29% on the funds with the highest expense ratios to 2.69% on those with the lowest. The reason, he was told, was to cover the costs of the plan, including having a toll-free number, Internet access, investment options from different fund families and broker commissions.

Richardson, who works for a small defense contractor and whose name we changed for privacy concerns, was shocked.

Think your 401(k) is free? Think again. All 401(k) providers impose fees on top of fund expenses, and smaller companies are the ones who are charged the most. "The fact is, the financial-services industry isn't donating its services and doing all this work," says David Wray, president of the Profit Sharing/ 401(k) Council of America.

Just how much a company will pay for a 401(k) plan depends on the number of plan participants and the size of their account balances, Wray explains. Chalk it up to economies of scale: Large companies will bring in more assets than smaller ones, so the costs of running these accounts is dramatically lower. The smaller the company and the lower the account balances within the plans, the more it will pay.

The good news: Many employers cover these costs on behalf of their employees. A quarter of the companies surveyed in Hewitt Associates' "2007 Trends in 401(k) Plans" report said they cover the various fees associated with 401(k) plans. (The survey focused on large companies with an average 14,000 employees.) But if you work for a smaller company, chances are your 401(k) plan will carry higher investment costs and have fewer investment choices, to boot.

What can you do, then, if your 401(k) plan isn't all that great? Here are four strategies.

Get the Match
If your employer matches any of your contributions, your No. 1 priority is to maximize that match. "You must always get the match," says Gary Schatsky, a fee-only CFP in New York. A company match is basically free money into your retirement coffer, and that's not something you should pass by. "Give me an investment that underperforms the market by 1% a year and tell me you have a 100% company match on your contributions, I'll be more than happy to sign on for that," Schatsky says. "If it's a miniscule match, I might rethink it. But normally they come in flavors of 50% to 100% of contributions."

For Richardson, the company match justifies the high fees he has to pay on his funds. His employer matches 10% of his contributions, and last year, he got a profit-sharing bonus equal to 50% of his contributions. In all, he received $9,000 in free money on top of the $15,000 he invested.

Fund Your IRA
When faced with a bad 401(k), an Individual Retirement Account, or IRA, can be your retirement strategy's best friend. Here's how to use it.

Assuming you are contributing enough to your 401(k) to maximize your company match, the next place to turn is a Roth IRA. You won't get a tax-deduction upfront, but withdrawals taken during retirement will be tax free. "The Roth is not without tremendous long-term benefits," Schatsky says. As frustrating as it sounds to fork over those extra dollars to Uncle Sam that you could have saved with a tax-deductible IRA, it makes sense to do it. That's particularly true for young folks who are just starting their careers and expect to have higher incomes in retirement. For more details on Roth IRAs, click here.

Not only will you most likely have more retirement dollars by using a Roth, traditional IRAs are less appealing in this situation because many folks simply aren't eligible to deduct their contributions. If you're single, your 2008 Adjusted Gross Income (AGI) is more than $63,000 and you contribute to a 401(k) plan, you don't qualify for a deduction. For married folks, that figure is $105,000.

One loophole: If you're not an active participant in your 401(k) plan — meaning you don't contribute and neither does your employer — you qualify for a traditional IRA regardless of how much you make. (Not sure whether you were an "active participant" for the year? Take a look at your W-2 form. If the "Retirement Plan" box is checked, you were an active participant in an employer-sponsored plan.) To see which type of IRA is best for you, click here.

Keep in mind, both types of IRAs have contribution limits of up to $5,000 a year for 2008 ($6,000 if you are 50 or older). With a 401(k), on the other hand, you can save more: up to $15,500 this year, $20,500 if you're 50 or older. That can be an advantage for people nearing retirement, particularly if they don't feel comfortable with how much they've saved.

If your spouse participates in a 401(k) plan that's better than yours, he or she should increase contributions to the maximum allowed, Schatsky says. This way, you can choose to invest in an IRA only and without falling behind on your savings.

Make the Best of What You've Got
Maximizing the company match may be easier said than done if you don't like the funds in your 401(k). So focus on damage control, Schatsky says. "Try to pick the least-worst offerings." That means choosing the funds with the best long-term performance and the lowest fees. What your 401(k) lacks, you can make up with your IRA, says Marilyn Bergen, a CFP in Portland, Ore. "If all of the funds in your 401(k) are domestic stocks or bonds, you can use your IRA to buy emerging markets or international funds," she explains. (Use our Asset Allocator to find the right mix for you.)

Talk to Your Employer
Just because your 401(k) plan charges high fees doesn't mean your employer isn't on your side. If you work for a smaller company, chances are the fees are high because the accounts are fewer and account balances are lower. "Typically, when the plans are initially established, the fee structures look very onerous because there are no assets there," Wray says. But as these grow, the company can negotiate lower fees.

To do that, though, you'd need a proactive employer — and not all companies review their retirement benefits as often as they should. According to a 2007 retirement survey conducted on behalf of Transamerica Retirement Services, a retirement plan provider, 12% of companies never evaluate retirement benefits. Of those that do, small companies typically review their plans less frequently than large companies.

Wray recommends that employers evaluate and re-price their plans at least once in three years. If you don't see your plan fees go down within that timeframe, it's time to give your employer a nudge. For more on negotiating a better 401(k), click here.