Investing isn’t difficult.
You buy low-cost index funds or stocks of great companies that raise their dividend every year and hold for a long time. That’s how you build wealth over the long term in the markets.
The hard part is navigating all the misinformation and complex products out there that tell you you’re going to make a lot of money, but are really designed to make a lot of money for someone else.
[ad#Google Adsense 336×280-IA]And even one of the most beloved financial products, the 401(k), is ripping you off to the tune of $154,794 over your lifetime (or $277,969 if you’re a high earner), according to New York-based public policy organization Demos.
Demos created an “ideal” model of a two-earner family where each partner earned the median income for their gender, saving 5% of their income at the beginning and ending at an 8% savings rate.
It turns out, nearly $155,000 or 30% of the total return was lost to fees.
A family of high-wage earners missed out on nearly $278,000. If you save more than 5% to 8% over the course of your life, you’re paying an even higher amount of fees.
Here’s why.
Most 401(k)s offer their clients actively managed mutual funds. That means there is a portfolio manager deciding every day which stocks to “Buy,” “Hold” and “Sell.” Each time a stock is bought or sold, there are trading commissions. Plus, that portfolio manager and his team of analysts have to be paid. And they don’t work cheap.
Additionally, the fund company has to make money, as does the institution offering up the 401(k).
This often results in nearly a third of an investor’s gross returns being eaten up by fees.
Now, I don’t expect anyone to work for free. A 401(k) administrator deserves to be paid for its work, just like you do. But that doesn’t mean you have to pay the high fees that everyone else pays.
Here are three steps you can take to hang on to more of your money rather than giving it to the fund companies.
Use Low-Cost Index Funds
The average actively managed mutual fund charges fees of about 1.5%. An index fund, which adds or subtracts stocks only when an index does the same, has significantly lower costs.
For example, the Vanguard Total Stock Market Index Fund (VTSMX) charges only 0.17%.
That’s a savings of more than 1.25% per year. If your portfolio is worth $100,000, that’s $1,250 in your pocket instead of the fund companies’.
And in case you haven’t heard, you’ll most likely do a hell of a lot better in an index fund than you will in an actively managed mutual fund.
Over the past 12 months, only 40% of large-cap actively managed mutual funds beat their benchmark (an index). Small-cap funds did even worse. Only 31% of them beat their benchmarked index. Over 30 years, only 14% of funds hit their benchmarks.
Odds are you’re going to be in the wrong actively managed mutual fund and not make as much money as you can, plus pay exorbitant fees for the underperformance.
Solution No. 1: Use low-cost index funds in your 401(k). If your plan doesn’t offer them, talk to your benefits manager about adding them. Explain how much money is being lost to fees by not having them in the plan.
Use a Self-Directed Brokerage Account
Approximately 25% to 30% of all 401(k)s have an option to open a brokerage account within the 401(k), where the investor can buy and sell stocks, ETFs, mutual funds and even options.
For example, Fidelity’s self directed brokerage offers stock trades at $7.95.
If an investor bought a dividend growth stock like Intel (Nasdaq: INTC), reinvested the dividends and didn’t touch it for years, the only fee he would incur is that $7.95 commission on the purchase.
Whereas if he had bought a mutual fund, he could be losing out on 1.5% worth of returns every year due to fees. In the Intel position, the investor keeps 100% of the return.
The risk with a self-directed brokerage is that an investor can overtrade and/or make poor trading decisions. Only consider a self-directed brokerage account if you are going to buy quality stocks and leave them alone for the long term.
Solution No. 2: Use a self-directed brokerage account if it is offered in your 401(k) to purchase dividend growth stocks for the long term. If your 401(k) does not offer the self-directed brokerage, ask you benefits manager or 401(k) administrator to add it.
Consider an IRA Instead of a 401(k) but Only If…
For many employees, a 401(k) is a terrific deal. Mostly because of a company match. Some companies offer to match employees’ contributions at $0.50 on the dollar, usually up to 3% of their total salary.
So if you make $100,000 and contribute 6% of your salary to your 401(k), your employer will kick in $3,000. That’s $3,000 in free money. If you’re not contributing enough to your 401(k) to maximize your employer’s match, you’re just throwing away free money, which is insane.
And even if your fees are high, that free money will more than make up for it.
The other advantage of a 401(k) is that your contribution reduces your taxable income. So if you make $100,000 per year and contribute 6% to your 401(k), your reported taxable income will be only $94,000. The $6,000 you contributed will grow tax deferred until you withdraw the funds.
The maximum contribution in 2014 is $17,500.
But if you’re contributing $5,500 or less to a 401(k) and your employer is not matching the funds, it may make sense to put the money in an IRA instead of the 401(k).
The maximum contribution for an IRA in 2014 is $5,500. So if you put your funds in an IRA instead of a 401(k), you can more easily buy those cheap index funds or individual dividend growth stocks and avoid paying all those mutual fund fees over your lifetime. Plus, you’ll most likely outperform those funds.
But this only makes sense if you contribute $5,500 or less because if you contribute more than that, the reduction of your taxable income is likely worth the extra fees that you’re paying.
For example, if you are debating between contributing $7,000 into a 401(k) or $5,500 into an IRA, your taxable income would be reduced by an extra $1,500 with the 401(k) option. Even though the fees are going to be higher in the 401(k), it’s probably worth it if you’re paying less taxes.
Solution No. 3: Consider an IRA instead of a 401(k) if you contribute $5,500 or less AND your company doesn’t match contributions.
These three steps can potentially save you thousands of dollars in fees, perhaps even as much as $277,000. Be sure you speak with your tax advisor to ensure you’re maximizing your tax deferred strategies.
It’s a well-known fact that people don’t have enough funds for retirement. Make sure your funds are in your wallet and not your mutual fund managers’.
— Marc Lichtenfeld
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Source: Wealthy Retirement