For most people, a 401(k) is almost an ideal investment. Simply by filling out the paperwork for a typical plan, you get:
- Autopilot investing with every paycheck
- An immediate tax deduction
- The possibility of an employer match
- Tax-deferred compounding
- Decent diversification
The only problem is the costs. 401(k) plans are not cheap to manage. Unlike with a typical brokerage account or even an IRA, there are some fairly complicated rules your employer has to follow to assure the 401(k) plan stays in compliance with the law.
That costs money -- money that's above and beyond typical investing fees like mutual fund management fees and trading commissions. And guess who frequently gets stuck with the tab for compliance and other administrative costs?
How Do You Prefer to Pay?
While employers are allowed to pass on administrative costs to participants, the big question is how they pass them on. There are generally two methods employers follow. Both methods have advantages and disadvantages, and depending on your personal situation, you'll likely strongly prefer one method over the other.
1. Everyone pays the same amount: The biggest advantages of this method are that it more closely matches what's driving the costs -- the number of people in the plan -- and that it's far simpler to calculate each person's fee. In essence, the statement mailings and the regulatory compliance testing just care if you're participating and how much you're contributing, not what your balance is.
The effort to comply is essentially the same whether you've got $1,000 or $1,000,000 in the plan.
The key disadvantage of that method? It can be an incredible disincentive to a person who's just getting started in the plan.
Say you're just out of college with a $40,000-a-year salary, and you want to put away 5 percent of your paycheck. That's $2,000 -- of your hard-earned cash -- going toward your retirement. If your employer charges each participant $100 a year, you lose 5 percent of your first year's contribution to that administrative fee. A charge that large might make you reconsider getting started at all.
2. Everyone pays in proportion to his or her balance: The biggest advantage of this method is that it doesn't discourage new investors from participating. If you're just getting started, using the same assumptions as above, your charge might wind up at $4 for the year on a $2,000 balance (0.2 percent of your balance), rather than the $100 price tag from charging everyone the same.
Of course, on the flip side, the disadvantage is that the proportional charge can get downright painful near the end of your career. Say you've amassed a cool $1,000,000 balance near the time you're ready to retire. Using the same 0.2 percent proportional allocation method, you'd be paying $2,000 a year for the privilege of keeping your money in your 401(k). That's a pretty big chunk of change -- even for a millionaire -- to pay for what amounts to some basic recordkeeping and compliance testing.
Go Big or Go Home
For any investor with a long-term perspective, the first option is clearly the better choice. Even a $100-per-person-per-year fee is less than 1 percent of the first-year maximum contribution that person can make (the limits are $17,000 in 2012 and $17,500 in 2013). If you're at all fee-conscious, a flat charge like that would likely encourage you to put as much away as you possibly can, so that a bigger share of your money stays working for you -- rather than getting eaten up by fees.
In many respects, when it comes to your financial well-being in retirement, the act of investing matters as much as the rate of return you earn on your investments. The more money you regularly put away, and the longer you let that cash compound, the better off you'll likely be in retirement, virtually no matter what the market does along the way.
In the end, regardless of how your company's 401(k) charges its fees, it's hard to beat the tax benefits, potential of a company match, and just plain direct-from-the-paycheck convenience of participating in the plan. Because of those benefits, in spite of the fees, your 401(k) remains a great place to amass a retirement nest egg to take you through your golden years.
Chuck Saletta is a contributing writer to The Motley Fool.