No matter how diligent you are at socking away money into your 401K, you could still be contributing less than you think, thanks to hidden fees and plan costs. According to a study from AARP, about three in five Americans are unaware of how much they're paying in 401K plan fees.
Excessive 401K fees can eat away your returns. Let's assume that a worker invests $5,000 every year over a 35-year period in a 401K plan with an annual return of 4.9%. She would end up with $423,000 at the end of period assuming an annual fee of 0.5% of the total balance, and with $345,000 at the end of the period assuming an annual fee of 1.5% of the total balance.
To claim back control of your retirement account, here are five 401K fees to look out for.
1. 12b-1 Fee
Owing its name to the Securities and Exchange Commission (SEC) Rule 12b-1, a 12b-1 fee is a charge from a mutual fund to cover marketing, distribution, and administration expenses.
The original intent with this rule was to encourage mutual funds to invest in marketing so that more people would buy into the mutual fund. In theory, the more assets that a mutual fund can buy, the better the economies of scale. Unfortunately, the empirical evidence from the SEC shows that mutual funds with 12b-1 fees have higher expense ratios than those without those fees, and that the services rendered to earn the fees don't enhance the fund's performance.
By law, 12b-1 fees can range between 0.25% and 1% of a fund's net assets. Given that these fees have shown no benefit to investors, you should try to choose funds that don't charge 12b-1 fees at all. If all your available investment options charge such a fee, go with the one that charges closest to the minimum 0.25%.
2. Redemption Fee
A front-end load is one of many sneaky investment fees to watch out for. Front-end load funds have such a bad rap that many investment firms have started advertising no-load fund options.
However, there can be a catch. While no-load funds won't charge you for loading shares, those funds can charge you a fee for unloading your shares too soon. Known also as an exit fee, back-end load, or contingent deferred sales charge, a redemption fee is applied to an investor that exits a fund too soon. How soon is too soon? The minimum holding period ranges from 30 days to one year, so make sure to check your fund's prospectus.
Here are two useful rules of thumb when evaluating redemption fees:
The average minimum holding period to avoid a redemption fee is 65 days, so avoid funds that require you to hold onto your fund much longer than that. While your nest egg should be a last resort fund, you shouldn't be penalized for accessing your money when in need.
- The SEC limits redemption fees to 2%. However, some funds may charge as low as 0.01%. The lower the redemption fee, the better.
3. Exchange Fee
Diversification is a useful investment strategy to lower your market risk. For example, it's generally better to split your investment into three significantly different assets than to "put all your eggs in one basket." If one of your investments tanks, you still have two to fall back on.
Before you fire up the online dashboard of your 401K and transfer money from one fund to another, check for applicable exchange fees within your retirement plan. Even worse, some 401K plans may tack on additional load and redemption fees when you exchange between funds.
4. Individual Service Fee
On top of your plan's administrative fee, your 401K may incur individual service fees related to features that you opted into. You may incur individual service fees when:
Taking a loan from your 401K account;
Executing participant investment directions;
Opting for a clause to terminate a contract with your employer before the contract's expiration date; or
- Choosing an investment option that includes an insurance component (e.g. annuity).
There are many other types of individual service fees. Keep in mind that some individual service fees that are paid indirectly from the investment options you have chosen may not be listed in your quarterly 401K statement.
5. "Other" Fee
Along with those other fees, 401K plans can have a miscellaneous fee category for listing anything that is neither a sales charge nor an account maintenance charge.
Some examples of other fees are:
- Custodial expenses;
- Legal expenses;
- Recordkeeping expenses;
- Furnishing statement expenses;
- Toll-free telephone service fees;
- Transfer agent expenses; and
- Other administrative fees.
Depending on the terms of your plan, another fee may be a percentage of your assets invested in the fund or a flat fee.
The Bottom Line
Do your due diligence before choosing funds within your 401K plan. To get a full picture of your investment options, you need to go beyond their average returns. The two key documents that you need in order to find out more about applicable fees are the Summary Plan Description and the Annual Report.
Summary Plan Description (SPD)
Upon joining the 401K plan, you receive a copy of your SPD. You will receive an updated copy every five years if there are significant changes or every 10 years if there are no changes.
Annual Report (Form 5500 Series)
Every year you should receive a copy. If not, you can examine a free copy from the Department of Labor.