A few months ago, my husband and I were having dinner with my mom, and the topic of her 401K contributions came up.
She had just started a new job, and she wanted our opinions on which funds to choose.
My first question was, “Well, what are the fees on your fund options?”
Her immediate response was, “I don’t pay fees on my 401K.”
My husband and I looked at each other knowingly and shook our heads.
This didn’t surprise us.
According to a survey from TD Ameritrade
- 37% of people don’t believe they pay any 401(k) fees,
- 22% didn’t know about fees, and
- 14% don’t understand how to determine what fees they pay.
Yet 95% of participants in 401(k) plans incur fees.
We spent the rest of our dinner explaining the hidden fees of 401Ks: expense ratios.
In this post, I’ll share with you the explanation that we gave to her and answer a few questions:
- What are expense ratios?
- How much are your expense ratios costing you?
- And how can you avoid paying high expense ratios while investing in your 401K?
By the end of this post, you’ll know how to save money while investing in your 401K and be on the road to financial independence sooner!
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What is an expense ratio?
An expense ratio is a percentage of your retirement fund assets that you pay to participate in your 401K plan.
Essentially, it’s the recurring fee you pay to your investment company to invest in their 401K.
For your company you’re investing with (say Fidelity, T Rowe Price, or whoever you invest with), this is designed to cover their administrative, management, and investment fees.
Basically, when you invest with a company, they make money from you with this expense ratio.
These fees are taken out automatically from your investments, so you may never notice them.
Are you sure I’m paying fees on my 401K?
Yes, you almost definitely are.
While there are a few companies that offer fee-free investments (like Fidelity), almost every company that you invest with will charge you fees for investing in their 401Ks.
Think about it this way.
If your investment company wasn’t making money from you, why would they let you make money on their products?
They have to make money somehow, and that’s through your expense ratios.
A study by the Center for American Progress found that the average 401(k) plan charges a 1% fee.
This means that the average investor is losing 1% of their investments each year to the companies they invest with.
And, like my mom, most people invest in their 401K for decades without knowing they’re paying these fees.
Why is my 401K expense ratio so high?
For the most part, you’ll see higher expense ratios for actively-managed funds than passively-managed funds.
What does that mean for you?
The more people involved in your 401K, the more you’re going to pay.
For example, target-date funds (funds with a year identified in its name, like “2055 Retirement Fund”) often have the highest fees in your 401K offerings.
Why? Because someone is actively managing the investments within those funds to make sure you’re hitting your goals and getting good returns.
But while you’re getting good returns, someone is making good money from your investments, usually at .7% or higher each year.
Why do I need to pay attention to my 401K expense ratio?
Basically, high 401K expense ratios can demolish your hard-earned retirement savings- and you wouldn’t even notice.
In fact, these fees can be so high that they negate the tax benefits of investing in a 401K, especially for younger investors.
With a .70% expense ratio…
Let’s say you’ve managed to save up $100,000 in your 401K.
Your gross annual return is 7%, so you would expect to see your 401K grow by $7,000 this year.
But your expense ratio is .70%.
.70% seems small, right? It’s not even a full percent!
But when we take .70% from 7%, your net annual return is 6.30%.
Your 401K will only grow by $6,300 this year, and you’ve paid $700 in fees.
With a .11% expense ratio…
Let’s start with the same $100,000 in your 401K and a gross annual return of 7%.
If your expense ratio is only .11%, your net annual return is 6.89%.
Your 401K will grow by $6,890 this year, and you’ll only pay $110 in fees.
What is my expense ratio costing me in the long run?
In one year, $700 paid in fees may not seem like a lot- but let’s look at what this looks like in the long run.
Let’s say you invest $10,000 every year for 40 years and see about a 7% return every year.
With a .70% expense ratio…
Like I said above, with a .70% expense ratio, you would see a 6.30% net annual return.
By the time you’ve invested for 40 years, you’ll have a balance of $1,721,912 in your investment account.
With a .11% expense ratio…
Like I said above, with a .11% expense ratio, you would see a 6.89% net annual return.
By the time you’ve invested for 40 years, you’ll have a balance of $2,007,474 in your investment account.
What’s the difference?
By investing in funds with a lower expense ratio, you would have $285,562 MORE in your account than you would have with a higher expense ratio.
Because of the impact of compound interest, you would have 14% LESS in 40 years.
Wouldn’t you love to have an extra quarter of a million dollars by the time you retire?
How can I lower my 401K expense ratio?
With some time and research, you can step out of your high-cost funds and save yourself a lot of money for retirement.
Look at your current investments
Break out your paper account statements or log into your investment account.
Once you’re all set, look for the expense ratio of each fund that you are invested in. If you can’t find your expense ratio, call the customer service number of your investment company.
Now that you know your expense ratios, find your rate of return for each fund from the past 12 months. This should also be listed on your account statements and your online investment account.
Subtract your expense ratio from your rate of return to get your net annual return.
Now multiply that expense ratio by your total 401K balance.
How much did you pay your investment company last year?
Take a deep breath
I have a feeling that number hurts- and that you didn’t know it until today.
You might be upset that you didn’t know you were giving up that much money.
Unfortunately, there is nothing you can do to change the past.
So take a deep breath, step away for a few minutes if you need to, and then come back when you’re ready.
Remind yourself that you didn’t know better- and now that you know better, you can do better.
Then start making change so you don’t have to look at that number ever again.
Make changes and save your money
Now that you know what you’ve been paying in expense ratios, you know that anything lower than your current ratios will save you money.
Take another look at your statement or your investment company’s website.
In general, index funds and institutional funds have the lowest fees.
As a firm believer in The Simple Path to Wealth and index funds, I would highly recommend doing some research to learn how index funds work while offering low expense ratios.
If you’re interested in learning about index funds, check out this video from WhiteBoard Finance.
Once you know your current expense ratio and the lower expense ratio, click here to try the 401K fee calculator to see how much you’ll save by changing your investments.
If your plan doesn’t offer low-fee options, consider rolling your 401K over to a self-directed IRA that would allow you to invest in better funds.
If you receive an employer match to your 401K, invest enough to get the full match first, then invest what’s left in the IRA or another investment.
Wrapping It All Up
401K expense ratios can demolish your hard-earned savings, but there are strategies to reduce these fees and save you thousands.
At the beginning of this post, we started off with 3 very important questions:
What are 401K expense ratios?
How much are your expense ratios costing you?
And how can you avoid paying high expense ratios while investing in your 401K?
Now that you have the answers, it’s up to you to make positive changes to your 401K and grow your investments for retirement.
You can do it!
Were you surprised by your expense ratios? What changes are you making to improve your 401K expense ratios? Do you want to learn more about index funds and low-cost investments? What else do you want to know about your 401K and investing?
Leave a comment below and let me know!
P.S. If you’re curious how the conversation with my mom finished: She learned a lot and set up her new investments for low-cost index funds instead of target-date funds. She had a great first quarter of high returns and low expense ratios. My husband and I will be walking her through converting her existing investments soon!
Do you want to reset your money mindset?
Sign up here to receive the FREE 7-Day Money Mindset Reset course!
[…] you’re buying stocks, consider index funds that diversify your stock ownership (I recommend index funds with low expense […]
I don’t know a single thing about 401k’s so this was such a helpful post! My boyfriend just started his first “real” job after college so I’ll definitely be sending this his way. Great post!
Thank you for the helpful tips. I feel like there is always a catch to a good savings plan.
Helpful tips. Thank you
very helpful tips and tricks