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What is a 401(k) Plan and How Does it Work?

You've dreamed about retirement for years now. A sandy beach, a perfect tan, a cocktail in your hand -- life will be great once you decide to retire. While this may or may not be your ideal fantasy, retirement is a future reality and how you plan for it now will affect your ability to maintain your current standard of living.

401(k): Your Ticket to Retirement

You may be wondering, what is a 401(k) and how does it work? Millions of Americans are building their own retirement incomes via employer-sponsored plans such as 401(k)s. In fact, according to the Bureau of Statistics and Labor, there were more than 600,000 defined-benefit plans such as 401(k)s in the U.S. in 2016, with more than 70 million people participating in them. That's a lot of money being invested.

And think about how simple it is. As an employee, you elect to participate in your company's 401(k) plan contributing part of your pretax salary and, in many instances, by directing your own investments.

In this article, we will answer some common questions about the fees and expenses that may be paid by your 401(k) plan. The most important takeaway here is to make informed decisions about your investment, taking fees into account in your decision-making.

Your Retirement Plan Has Fees: But Maybe You Didn't Know That?

You may not be aware that your retirement fund charges fees. Relax, many Americans are unaware of this fact, but it is important to note that fees and expenses paid by your plan may substantially reduce the growth in your account.

Retirement Plan Fee Example

You've been working and contributing to your 401(k) for 30 years. You've managed to save $10,000 a year for each of those years. If you average 7% returns annually and pay 0.5% in annual expenses, you've just saved $920,000. However with 1.0% in annual fees, that total drops to a little less than $840,000 — and if the number is higher, say 2.0% in annual fees, your finishing total is just under $700,000.

Why is this important? Simply put, the cumulative effect of the fees and expenses on your retirement savings can be substantial.

What are 401(k) Plan Fees and Who Pays for Them?

An investor pays an ever-increasing amount in fees as account balances grow because the fees are based on a percentage of assets and the particular investment the employee selects.

Fees diminish the portfolio's overall returns because every dollar taken out to cover management costs is one less dollar left to invest in the portfolio to compound and grow over time. So in addition to paying potentially hundreds of thousands of dollars in avoidable fees, you may also be losing that amount in portfolio returns over time.

401(k) plan fees and expenses generally fall into three categories:

  1. Plan Administration Fees: These are the fees associated with the operational tasks, such as record keeping and legal services. The key is to understand who is paying for these costs -- you or your employer? Many employers pay the fees associated with these operations, while others pass them on to you.
  2. Investment Fees - There are a number of different fees tied to your investment. One type of fee is tied to expense ratios. Expense ratios are the annual fees linked to mutual funds, index funds, and exchange-traded funds. Try to pick funds with the lowest expense ratios.
  3. Individual Service Fees - These are fees associated with optional features offered under a 401(k) plan. Individual service fees are charged separately to the accounts of individuals who choose to take advantage of a particular plan feature. For example, individual service fees may be charged to a participant for taking a loan from the plan to buy a house or pay other bills or for executing participant investment directions.

More Information About Fees and Expenses Associated with a 401(k)

If you have questions about the fees and expenses charged to your 401(k) plan, you have a number of places to go for information. First, start with your plan administrator for specific information. Here you can get copies of your account statement showing show the total assets in your account, how they are invested, and any increases (or decreases) in your investments during the period covered by the statement.

You can also consult the business section of major daily newspapers, business and financial publications, rating services, most of which can be found online.

If, after doing your own analysis, you have questions regarding the rates of return or fees of your plan's investment options, you may want to consult with a tax professional for a better understanding.

Other Factors Impacting Fees and Expenses

As you continue to educate yourself on retirement plan options, you'll likely want to know more about any other types of fees you could be hit with.

If you are having an investment adviser "actively manage" your investment, your costs will be higher. The higher fees are associated with the more active management provided and sales charges from the higher level of trading activity.

If your funds are "passively" managed, your fees will be lower. Passively managed funds work by seeking to obtain investment results of an established market index (think Standard and Poor's 500), by duplicating the holdings included in the index.

Also, optional features, such as participant loan programs and insurance benefits offered under variable annuity contracts, involve additional costs. Consider whether they have value to you.

What is a 401(k) Plan and How Does it Work: Additional Resources

Listed below are some links to help you continue your research. For the most accurate information, you should contact your plan's administrator, a financial planner, or a skilled employment law attorney.

Legal Questions About Your 401(k)? Speak with a Lawyer

Retirement planning is a proactive activity. If you wait too long, you may not have the income you need to sustain your standard of living. That's why having good, solid investment advice and planning from a skilled professional can make all the difference. If you're seeking answers to your legal questions, consider speaking with a lawyer with a background in ERISA laws today.

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