Why Most 401(k) Plans Should be Abolished

401(k) plans are seen as a competitive benefit to employees that supposedly enhances the compensation package, but the truth is often just the opposite.  As I have explained before, every dollar that employers contribute in the form of matching or profit sharing contributions could have otherwise been paid out as a bonus.  While the tax deferral brought about by forced savings might seem like a good idea, the unnecessarily high fees that most participants incur often outweigh the advantage of the tax deferral.  Furthermore, offering a retirement plan has a litany of compliance requirements, which take time and resources (both financial and non-financial) away from running the business.

But perhaps the most compelling reason has to do with inadequate employer and employee participation (this is the case for most plans I see), as the main advantage of company sponsored plans is the ability to defer significantly more than what could otherwise have been contributed to an IRA, which currently has annual limits of $5,500 plus a $1,000 catch-up contribution for those over 50.  If an employee is only contributing $2,000 annually and the employer puts in another $500, for example, that $2,500 doesn’t even come close to the IRA limit, yet in many cases, the employee could have purchased the same funds available in the company sponsored plan at a lower price because IRAs don’t have record keeping, administration, or custodial fees (low cost index funds are a prime example).  In addition, financial advisors usually get paid from participants’ accounts regardless of whether or not the participant uses the advisors’ services, whereas the only way for an advisor to get paid from an IRA is to come to an agreement with that individual.  If employers are worried that their employees may not make the effort to contribute to an IRA, they can still hire a financial advisor to educate their employees.  In most cases, this solution makes far more sense, but employers rarely take the time to think about why they even have a plan, usually because they are too busy running their business, and the advisors, administrators, and record keepers are too busy extracting money from the participants’ accounts to tell their clients that they aren’t adding enough value to justify keeping the plan.

Granted, in some instances, highly compensated employees will not be able to receive a deduction (or only a partial deduction) for traditional IRA contributions and may not be able to contribute to a Roth IRA due to their income, but they can still save as much as they want in a taxable account.  If they invest in low cost, tax efficient, passively managed funds as they should, then giving up the tax deferral will be far less costly than investing in less tax efficient investments such as actively managed funds.

Some employers may object to terminating the plan because of outstanding loans, but this claim is erroneous due to the fact that employees can simply roll over the outstanding balance into an IRA.  As it states on the IRS website:

“Plan sponsors may require an employee to repay the full outstanding balance of a loan if he or she terminates employment or if the plan is terminated. If the employee is unable to repay the loan, then the employer will treat it as a distribution and report it to the IRS on Form 1099-R. The employee can avoid the immediate income tax consequences by rolling over all or part of the loan’s outstanding balance to an IRA or eligible retirement plan by the due date (including extensions) for filing the Federal income tax return for the year in which the loan is treated as a distribution. This rollover is reported on Form 5498.”