In part two of my guide on the 401K, let’s talk about 401K scams!
In part one, we talked about the upside of a 401K. In part two below, I’ll explain why 401K can be a scam and how you can protect yourself.
No matter where you work, your 401K will have traps. Learning to avoid the traps is critical to maximizing your retirement money. Let’s go!
- Are 401K Scams Real?
- How to Avoid 401K Scams
- Common 401K Mistakes to Avoid
- Are 401K Scams?
- What’s Next?
Are 401K Scams Real?
In theory, a 401K plan is a great retirement tool.
You should always max out your 401K every year.
Why? You defer paying multiple types of taxes that save you a lot of money over the decades.
But in practice, a 401K plan is full of scams targeting ordinary Americans.
How is a 401K a scam, you ask? Let’s start with the government.
The Root Cause of 401K Scams
The government, specifically the IRS has strict rules around the 401K.
These rules are meant to protect ordinary employees who know little about financial management.
For example, one rule says the company must invite an investment professional to educate employees on their 401K plan face-to-face.
Another rule says the employer must direct deposit your paycheck to a 401K plan within 15 days.
These rules are put in place for the right reasons, meant to protect you from fraud.
But these rules are also expensive, and employees end up paying for them.
Below, I’ll list out some of the common scams of a 401K plan.
401K Scams #1: Too Few Choices.
One of the 401K rules says that “less is more.”
Your 401K plan, no matter your employer, can only offer you a limited set of funds.
The intent of the rule is to help you streamline your investment decisions. If I give you thousands of investment choices, you might be overwhelmed and invest in something totally esoteric, like gold.
Unlike your IRA, your 401K plan has very limited choices for where you can invest your money.
A typical 401K plan has maybe 50 investment funds to choose from. Comparatively, Vanguard alone has thousands of index funds.
In order to have a diversified portfolio, you might want to invest across very different assets, from bonds, stocks, to alternatives.
But you won’t find them all within your 401K.
Your 401K plan will unlikely span across a few stocks, a few bonds, and maybe one Treasury.
401K Scams #2: Poor Performing Funds
It would’ve been fine if your 401K has only a dozen funds but they are the best ones out there.
But oftentimes the opposite is true.
For example, your 401K plan probably doesn’t have most of my top Vanguard funds.
Count yourself lucky if you have more than three low-fee index funds at all.
I’ve worked at many Fortune 500 companies. In all of my 401K plans, there’re maybe 5 low-fee index funds out of 30 investment choices.
I can’t imagine how much worse this situation might be for small firms.
How did we get to this place? Well, it turns out it has to do with the IRS.
The government requires that an investment professional puts together the list of funds for every 401K plan.
Guess what happened?
Crappy investment funds pay money (as fees) for these investment professionals to add their crappy funds.
In fact, some fo the worst-performing investment funds are the most likely to appear inside 401K plans!
The best active funds don’t need to be part of people’s 401K. They’ve got rich people willing to pour millions of dollars into them.
So the 401K plans are left with high-fee, active investment funds with fancy names but the most atrocious performances.
You are better off just investing in the S&P 500 index fund. Seriously.
401K Scams #3: High Management Fees
Your 401K plan might also be full of hidden fees.
The most important fee is the management fees, which makes up the bulk of what an expense ratio is.
The expense ratio is how much fees the fund will charge you as a percentage of investment.
The vast majority of an expense ratio goes to the costs of managing your funds, or, management fees.
Every investment fund has an expense ratio.
A management fee of 0.5% means the investment fund will take 0.5% of your investment as fees every year.
So if you invest $100,000, a management fee of 0.5% will take $500 a year.
An index fund’s expense ratios are very low, oftentimes near 0.03%. An active fund’s expense ratios tend to be higher, even exceeding 1.0%.
Here’s my advice:
For your 401K plan, NEVER pay for any investment fund with an expense ratio that exceeds 0.50%.
It’s not that no investment fund should ever charge a 1.0% in expense ratio. It’s that if a fund is worthy of charging 1.0%, it won’t appear in a 401K plan.
There are a few hedge funds that charge a lot of fees and delivers great results. But their investment funds are 100% closed to you and only available to high net worth people with at least $10 million dollars.
So whatever high-fee investments that land in your 401K is likely just junk.
401K Scams #4: Recurring Fees (12b-1 and Sales Commissions)
Some 401K funds charge other fees on top of management fees to increase the expense ratio.
Some of these fees are downright outrageous, from operations, advertising to sales fees.
To make matters worse, the financial industry hides these fees in language that confuses us.
They’ll charge you fees in the form of “loaded sales commission” and a “12b-1” fees.
What is a 12b-1 fee? Well, it’s a fee that is part of the expense ratio and covers things like marketing, promotional and service expenses.
A great fund should have an extremely low or non-existent fees charged for marketing purposes. Their results should be their marketing.
Plus, marketing fees have nothing to do with running a great 401K fund.
The Vanguard Wellington, for example, does zero marketing because its reputation and performance stand on its own.
You should only buy funds with “no loads” or “zero sales commissions”. Never pay a one-time fee to buy, sell, or transfer your money!
If you notice a high expense ratio, consider the fund a potential scam and avoid it!
401K Scams #5: Impossible to Transfer Out
Some shady investment firms will do anything to try to keep your money forever.
Some fund managers make it impossible for you to transfer your money.
They’ll not have any instructions online on the fact that you can actually transfer your money.
And they’ll not give you any direction on how you can transfer your money out.
Oftentimes, you have to call them directly to transfer your money and fill out paperwork.
They’ll ask you to coordinate with your ex-employer and do a series of other tedious tasks.
You might also get charged a $100 fee just for transferring your money out.
Shockingly, all of these scams are 100% legal.
Just know that these barriers, inconveniences, and discomfort should not discourage you from doing the right thing, which is this:
Once you leave a job, always rollover your 401K from the old job into an IRA, preferably to Vanguard’s IRA.
How to Avoid 401K Scams
Many investment management firms literally steal your money via legally verified fees.
Fees kill your growth. The more fees you pay, both one-time and recurring, the less you’ll have when you retire.
Here’s what you must do to avoid getting scammed.
Tip #1: Keep Net Expense Ratio Below 0.25%
When you select an investment, stick with investment funds with a net expense ratio of 0.25% or less.
Most of my Vanguard funds have an expense ratio of 0.05%.
Even Vanguard Wellington, an actively managed fund, has an expense ratio of only 0.17% for admiral shares.
Tip #2: Look at 10-year performances
As they always say, historical performance is no indication of future returns.
But how a fund has been managed in the past gives you many clues.
However, don’t look at the performance in the past year or the past five years only.
You want a fund that has been around for at least 10 years, preferably 20 years or more.
Why? Because you want to understand the full picture by looking at a fund that’s gone through some ups and downs.
When you don’t look far enough out, you might find a fund that’s done well during good times, but you have no idea how it’ll do when the times are bad.
Some funds can make a lot of money in one year, but can also lose a lot the next year.
Some funds are highly volatile and volatility is hard to see with only a few years of data.
Tip #3: Avoid One-Time Fees
In addition to keeping your net expense ratio low, you also want to avoid paying one-time fees of any kind.
For example, never pay one-time fees to buy, sell, or transfer your 401K money.
Do not pay consulting fees to talk to anyone about your portfolio.
If you need a money manager, get a good one at an independent place.
Tip #4: Look into Brokerage Account
This is a hidden secret that not many people know, so listen carefully.
This secret has saved me a lot of money.
If your 401K plan has limited options, see if your plan has a self-directed brokerage window.
Fidelity, for example, has a “brokerage window” called BrokerageLink for every 401K plan that contains thousands of index funds.
If your company allows, Fidelity can transfer your 401K money directly to a brokerage account where you can access all the funds Fidelity offers.
This move can open the door to more, better investment choices for you.
Not every company allows its employees to transfer their 401K money to a brokerage account. So if yours doesn’t allow, talk to them and see. if they understand they have this option available!
Tip #5: Roll Over 401K Money to IRA
As soon as you leave your job, you should transfer your 401K money to an IRA.
This is called a 401K rollover.
When you roll over, you’ll have thousands of investment choices, no longer limited by your 401K plan.
Some fund managers make it difficult for you to take the money out.
Many people get frustrated and never roll over their 401K, leaving their money to rot in bad funds.
I recommend everyone transfer their 401K to Vanguard the minute they quit their job.
At Vanguard, you can access all the best funds in the world.
Tip #6: Ask Employer for Better 401K Options
Not liking your 401K plan?
An often overlooked option is to talk to your HR department and alert them of this reality.
Often, your employer is not deliberately trying to scam you.
If you request changes and clearly outline the reasons, your employer might listen and say yes to your requests.
In fact, many employers appreciate the feedback.
Often employers want to keep their employees happy and will try to make you happy, too.
If asking your employer alone doesn’t work, get more people to ask.
Many people requesting the same change can more likely to bring change within a company.
A simple change can impact your net worth by a lot.
Even if you don’t like your401K plan, you should invest to receive 100% of your employer’s matching contribution.
If you can find a stock index fund that has 0.10% in management fees, you should max out your 401K.
Don’t know if your 401K is worth it? Reach out to me directly below and I’ll help you figure it out.
Common 401K Mistakes to Avoid
Besides avoiding 401K scams, you should also avoid making mistakes yourself.
Some of the biggest problems with 401K management are the result of people fiddling with their accounts too much!
Once a plan is set up according to market conditions, don’t keep looking at it.
This is also called investing for the long-term. Set it and forget.
Research shows if you select the right funds and forgot about it for 20 years, your fund will perform better!
What other mistakes should you avoid with the 401K? Read on!
Mistake #1: Cashing Out Too Soon
Of course, the worst thing you can do with a 401K account is to cash out before retirement.
You get a 10% penalty when you do that plus all the taxes you have to pay.
Cashing out is the final option if you really need money. You shouldn’t cash out unless someone’s life is literally on the line.
That money you cash out will be nearly impossible to replace later in your career.
I am so serious about this rule that if you are thinking about cashing out 401K, email me first.
Mistake #2: Investing Too Little to Get Maximum Matching Funds
Some companies have more rules than the IRS with regard to what you need to do to qualify for match.
One common mistake is to not put a high enough percentage of your earnings into savings. This decreases or eliminates the amount of your employer match.
Make sure you are clear on the company requirements for employee match!
Your plan should clearly state its employer match policy, and if it doesn’t, you should ask for clarification.
Mistake #3: Taking 401K Loans
Like cashing out, it’s bad to take loans on your 401K. The damage to your future retirement is irreparable.
There is also the interest rate that you’ll be responsible for.
You might also face restrictions on what you can withdraw the funds for.
Just like getting the penalty of 10%, taking out a 401K loan exposes you to more issues.
Should you take out a 401K loan? If nobody is dying, the answer is no!
Mistake #4: Investing Too Aggressively
Many of the losses that 401K plans incurred in 2008 were the result of aggressive investing.
The more aggressively you invest, the more you might lose.
If you don’t have the stomach to keep going when prices free fall, you should reconsider your aggressiveness.
Similarly, international stocks have not always performed well, taking nose dives when the U.S. market is rising through the roof.
But sometimes, the international market could have moments of dramatic rise, leading people to believe that they should invest more in emerging markets.
I caution everyone against making aggressive moves to “get rich quick.”
Mistake #5: Investing Too Conservatively
On the flip side, you also don’t want to be too conservative.
The U.S. stock market is still the best place to invest your money, and you shouldn’t sit it out.
Many people got scared due to the 2008 recession, and moved their money into bonds or cash for years, missing out on one of the greatest growth decades of our times.
Women tend to be more conservative than men when it comes to investing. And this difference gives women a significantly lower net worth compared to men.
You need to take some risks. And when things crash, see it as an opportunity rather than the end of an era.
Even for people close to retirement, I recommend keeping at least 50% of your net worth in the stock market.
Are 401K Scams?
What if you realized that your 401K plans suck?
Should you still put money into your 401K?
Yes, you should still invest in your 401K plan. Here’s why.
First, you want to invest so you can maximize your company match. If your company match is 6%, invest at least 6% of your salary to get the match.
Second, you should still invest more money into your 401K for the tax deduction.
Third, if your 401K has some U.S. market index funds, you should max out your 401K.
Since most 401K plans offer at least a few index funds, really, you should max out your 401K every year.
Looking for investment funds near retirement? Check out Vanguard Wellington Fund (VWELX): Retirees’ Favorite
Read the popular forecast I wrote on When Will the Stock Market Crash? I Predict 2020
Learn the fundamentals of building a pro wealth mindset that makes money: Want to Make Money? Build a Pro Wealth Mindset First