The Invisible $500K tax in your 401(k)
The default-setting trap that quietly eats retirement nest eggs.
From a young age we have been taught about the importance of retirement and saving money. And at the crux of retirement is the 401(k).
There's so much positive sentiment around the 401(k) because it combines retirement savings, tax advantages, automated deposits, and sometimes a match from your employer.
But for many individuals, there is a hidden, cascading fee eating hundreds of thousands of dollars from their retirement nest egg.
Target-date funds
The primary investment instrument inside of a 401(k) is a target-date fund. These funds invest in a mix of assets (stocks, bonds, foreign exchange, etc) and are designed to automatically adjust as the fund gets closer to the target date.
The target-date is a prefixed date based on your date-of-birth. For example, someone born in 1996 will likely be invested in a 2060 target date fund. And by default, 401(k) plans will automatically enroll individuals into target date funds.
Like any investment fund, these target-date funds have fees, known as the expense ratio, expressed as a percentage of the money you have invested. For example, a 0.2% expense ratio means you pay $2 for every $1,000 invested.
These fees are not a separate bill you receive in the mail, instead the percentage is taken directly from your gains. It sounds small, but many target-date funds have expense ratios north of 0.64% and the fees compound exponentially against you.
The numbers
Assumptions:
- $24,500 starting balance
- $25,000 annual contributions to the 401(k)
- 30 year time horizon
A target-date fund with a 0.64% expense ratio would cost you:
30-year fee drag on a maxed 401(k)
| Average return | Contributions | Timeline | Lost to fees |
|---|---|---|---|
| 7% | $25,000 / yr | 30 yrs | $285,000 |
| 10% | $25,000 / yr | 30 yrs | $536,000 |
The craziest part is that there is an estimated $5T sitting in target-date funds. So, you are potentially leaving half a million dollars on the table just for the convenience of "setting and forgetting."
Building your own fund
You don't have to keep paying these ridiculous fees. Most 401(k) plans offer lower-cost alternatives with similar performance.
For example, Vanguard's 2060 target date fund has an expense ratio of 0.08%. At 0.08%, you'll be paying $71K in fees versus the $536K at 0.64%.
Alternatively — and people never think of this — you could build your own portfolio that mirrors the target date fund’s performance just by individually picking the stocks, bonds, etc to invest in.
What’s your next move
The difference is not abstract. It represents a down payment for a home, years of living expenses, and even a larger inheritance for your kids. Or simply the freedom to retire early.
Log into your 401(k) and explore the alternatives available to you.