What Should You Do With a Subpar 401(k)?

No doubt about it, many company retirement plans--especially those offered by smaller employers--are not serving savers well. Their administrative costs are often too high, employer matching contributions can be lackluster, and investment lineups can be full of costly also-rans. 403(b) plans, which are offered to educators, can be even worse.

If you suspect your plan is subpar, here are the key steps to take. (Note that I’ve used “401(k) plan” interchangeably with company retirement plan during the course of this article, but all of the ideas contained herein can be applied to 403(b) and 457 plans as well.)

Step 1: Ask and answer: Just how bad is it, anyway? The first step when deciding how to deal with a subpar company retirement plan is to do a bit of homework on just how bad it really is. Checking the expenses on the investment options is a good place to start, because it's usually pretty easy to find the data. (If your plan includes collective investment trusts rather than mutual funds, finding information on the options can be a bit trickier because disclosure requirements are less stringent.) If you see a lot of expense ratios of 1% or more, even on "vanilla" investment types like large-cap blend funds, that's a red flag that you've got a high-cost plan. Also check up on the administrative expenses on the plan; high administrative expenses can chip away at your returns, even if you focus on the cheapest investments available inside your plan. This article discusses how to conduct a review of the quality of your 401(k) plan.

If, after some due diligence, it turns out that your plan could use some improvement, alert your plan’s overseers, whether that’s a 401(k) plan committee or your firm’s benefits manager. Be as specific with your criticisms as possible and put them in writing, bullet point by bullet point. Plans can and do improve thanks to feedback from well-informed participants who take the time to share it.

Step 2: Take advantage of the tax-efficient 'gimmes.' Assuming you've found your plan lacking, that doesn't mean you shouldn't put a penny in. If your employer offers matching contributions on the money you invest, it's worth steering at least the minimum amount needed to earn any matching contributions. After all, those matching dollars, assuming you stay around long enough for them to vest, provide you with a 100% return on Day 1.

If you have additional assets to invest, above and beyond what you need to put in to pick up matching contributions, consider steering those dollars into an IRA. Within the confines of an IRA, you can avail yourself of tax benefits that largely mirror those of company retirement plans, and you can usually circumvent the type of administrative expenses that can erode the returns of 401(k) plan participants. You can set up an automatic investment plan for your IRA contributions, much as your 401(k) contributions go in on autopilot. Because an IRA doesn’t constrain you to a preset list of investment choices, you can also invest in very low-cost products, such as total market index funds or target-date funds. Of course, the “open architecture” of IRAs can invite problems, too; the choices can be overwhelming, and it may be tempting to invest in very narrowly focused investment products that you wouldn’t find in most 401(k)s.

An additional option for tax-advantaged savings, assuming your company retirement plan is subpar, is to use a health savings account for additional savings. If you’re covered by a high-deductible healthcare plan, then you can also save within an HSA. HSAs offer even greater tax benefits than company retirement plans: pretax contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenses. Of course, if your company retirement plan isn’t so great, your employer-provided HSA might not be, either. But there’s a workaround if that’s the case; you can periodically transfer money from the “captive” HSA to one of your own choosing, as discussed here.

Step 3: Determine what to do with any additional investable assets. For some savers, investing enough in the company retirement plan to earn matching contributions and funding an IRA (and even an HSA) up to the limits will tap out their investable assets. But if you've taken those steps and still have money to invest, the question is whether to steer additional assets--above and beyond what you need to earn matching contributions--into the 401(k) or whether you're better off employing a taxable brokerage account.

The answer depends on a few different variables, as follows: • 401(k) quality: Just how bad is the plan? (See Step 1, above.) Unless your plan is truly terrible, you may be better off investing inside of it rather than forgoing it altogether. • The quality and tax efficiency of the investments in the taxable accounts: Investing in a taxable account may be the better option if you're able to invest in securities that make few ongoing distributions of income, capital gains, or both. • The investor's tax bracket at the time of the contributions: The ability to make pretax contributions--as is the case with 401(k)s--will be more valuable to the investor who's in a high tax bracket at the time of that contribution than it will be to the person who's in a lower tax bracket. • The tax bracket at the time of withdrawals: Withdrawals from taxable accounts receive more favorable (and flexible) tax treatment than withdrawals from traditional 401(k)s. Investors pulling from their taxable accounts will owe capital gains taxes, whereas money coming out of a traditional 401(k) is taxed at the investor's ordinary income tax rate, which is higher. Moreover, because the 401(k) money has never been taxed, investors owe taxes on the entire withdrawal, not just the appreciation; taxable-account investors, by contrast, will only owe tax on their gains. Finally, 401(k) assets are subject to required minimum distributions at age 70 1/2. For investors who expect to be in a high tax bracket upon retirement, having assets in a taxable account--and enjoying more favorable taxation on the distributions--will tend to be particularly beneficial.

This article does a deep dive into deciding between a company retirement plan or a taxable brokerage account.

Step 4: Make the best out of your 401(k) choices. Assuming you've determined that it makes sense to invest inside of a 401(k), even if you've found it wanting, there are a few ways to derive the maximum benefit. Here are a few routes to do so.

• Embrace index funds: Investors' ongoing preference for index funds hasn't been lost on 401(k) plan providers; these products are showing up on more and more plan menus. If the plan's options include index funds--offerings that track a given market benchmark rather than attempting to beat it--you can obtain broad market exposure at a reasonable cost. Even if the index funds in your plan aren't the best, you're probably still better off going the index route than you are opting for a lackluster active fund. True, the active manager--even the one with a subpar past record--has a shot at beating his or her benchmark, at least in theory. In practice, however, the active fund's expenses--as well as transaction costs that aren't reflected in its expense ratio--weigh heavily on that manager's ability to beat the benchmark. • Sink a lot into the best options: It's natural to want to craft a 401(k) portfolio that's diversified across all of the major asset classes (bonds and U.S. and foreign stocks), but that might not be practical or prudent if your company plan doesn't offer viable options in all of these areas. If your plan features a few standout options and the rest are subpar, load up on the few decent funds and avoid the rest. You can use your IRA, your taxable accounts, or your spouse's retirement plan to delve into those asset classes and investment styles in which your own plan is lacking. For example, say the stock funds in your company plan are poor but the lineup does offer a top-quality core bond fund. Even though your overall asset-allocation plan calls for just 30% in bonds, you could sink a big share of your 401(k) portfolio into the bond fund and then go light on bonds in your other accounts. The key to making this strategy work is to look at all of the assets geared toward a particular goal or time horizon in aggregate. Morningstar.com's Instant X-Ray can make easy work of this task. Just enter all of your retirement-related holdings into the tool, then click Show Instant X-Ray to see aggregate asset-class, investment style, and sector data for all of your holdings. • Investigate the brokerage window. Increasingly, 401(k) plans--particularly those from large employers--are offering so-called "brokerage windows," which may also be called "self-directed accounts." If your plan offers such an option, you'll have the opportunity to delve into hundreds of other mutual funds, stocks, and even exchange-traded funds that aren't part of your 401(k) plan's preset menu. But be sure to read the fine print. You may pay an extra fee (often levied annually) to participate in the brokerage window, and those extra costs can quickly erode the extra returns you might gain by venturing beyond your plan's preset menu. In addition, you may pay separate transaction costs to buy and sell securities that are part of the brokerage window. Finally, using the brokerage window may require additional work on your part. Whereas most 401(k) contributions are deducted directly from your paycheck, thereby adding valuable discipline to the investment process, you may have to actively make the trades into investments via your brokerage window. This article takes a closer look at brokerage windows.