What’s in a 401(k)?

That’s not a rhetorical question. I am seriously asking you to take a deep dive into your 401(k). There are numerous articles written on the 401(k)s, but they are all misleading in one continuous manner; they are written in a way that assumes this is some sort of centrally managed government program. Nothing could be further from the truth.

401(k)’s full name is 26 U.S. Code § 401(k) – Qualified pension, profit-sharing, and stock bonus plans as listed in the United States Codified laws. All this means is that the U.S. Code allows employers to set up plans where the employee and employer can contribute money, on behalf of the employee. The employee will not be be taxed on his/her respective contributions until withdrawal at 59 1/2 and recognize tax savings today; the employee will not be taxed on the employer portion until withdrawal either.

All this really means is that an employer sets up a special account for you that is held in trust by a third party. However, what is in that special account differs drastically by each individual plan. IRS rules mandate that only mutual funds can exist in a 401(k) account. There are loopholes around this, but most of America, is either not aware of the loophole or not interested.

The mutual funds that exist in my 401(k) are wildly different. Some are large cap growth, some are bond specific, others are aggressive international; and some have expense ratios of 1% and others have expense ratios of 0.1%; that’s a huge difference when you are talking about returns on investment. For Example:

Net Returns of two comparable investments of $10,000 over three years with different expense ratios.

This is a small disconnect over three years, but multiply it over 20 years and the expenses really start adding up. My primary issue with these is that these expenses are not seen by the employee/investor. They are hidden away in disclosure statements, usually along with a bevy of other fees, such as service fees, marketing fees, load fees, and on and on.

I am not going to teach you today how to capitalize on loopholes to escape this; as your employer may not even allow the loopholes, but I am trying to raise awareness to paying attention to the mutual funds you are investing in through your 401(k), 403(b), or 457 plans. These fees, albeit small, can really eat into your overall returns over twenty years. If you access your 401(k) through the web; I can assure you that the disclosures for each fund is somewhere there with a listing of what the mutual fund is charging you. If the disclosures can not be found on the site of your plan’s trustee; put the mutual fund name or ticker into google and find it throughout the web.

Now, for my favorite element; the loopholes. Many company executives were growing tired of being limited to mutual funds, because like me, and hopefully now you, they know it’s a bad deal. So where there is money to be made; the market delivers. What some plan administrators came up with in cooperation with the trustee holders is essentially the ability to “Make Your Own Mutual Fund.” Or as I have heard it described as the “Window, ” where you are looking through the transparency of a mutual and buying and selling the assets behind it.

Now for my least favorite part of 401(k) discussions. What happens if you start doing really well and amass a large 401(k) balance on top of your salary; and other very successful investments? Well, my 401(k) balance right now shows 100k, but it’s really not. It’s 50k. Why? render unto the IRS the things that are the IRS’. How can you escape this? Stay tuned for Friday and I will detail out how you may be able to escape losing half of your 401(k) to taxes.

**Please remember that I am not a tax or investment professional. I am someone who lives and breathes taxes and investments. Any piece of information you receive should always be consulted with an investment or tax professional, such as a series 7 broker, Registered Investment Adviser, Enrolled Agent, or Certified Public Accountant.

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