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This is the first in a four-part series covering one of the most powerful tools on the road to retirement security: tax-advantaged savings. Even if you don't have a 401(k) through your employer, you still have access to other tax-deferred plans that can help you jump-start—and turbocharge—your retirement. What follows are the four key strategies you need to know. Today: Keep costs low.
Over the past few years, retirement savers have absorbed an important message: Keeping costs low is crucial. The lower your investment fees, the more gains you can hold on to.
Fund fees are falling, according to a 2015 survey by the 401(k) rating firm BrightScope and the Investment Company Institute trade association. From 2009 to 2013, 401(k) stock funds' average expense ratio—the percentage of assets each year that go to the manager, not you—fell to 0.54%, down from 0.64% in 2009. Trends are similar at 403(b)s, the usual retirement plans at nonprofits and state and local governments.
In your retirement plan—especially if you work for the federal government or a large company or nonprofit—you might see low-fee funds not open to you otherwise, since individuals don't have a big plan's bargaining power. At a smaller operation, however, you might find yourself paying high fees instead. The BrightScope/ICI 401(k) data show that workers in small plans—those with less than $10 million in assets—pay an average of 0.81% for domestic stocks, vs. just 0.44% for savers in plans holding at least $1 billion. Over 25 years, paying those higher fees would set you back $34,000, assuming 6% average annual gains on a $100,000 opening balance.
"When it comes to retirement investments, one of the first things you should look at is the cost of each fund," says Wharton economics professor Olivia Mitchell.
Know your costs. Have a 401(k)? Check your account statements for fund fees. Have a 403(b)? You may have to search company websites or call customer service to get the expense ratios. Work for the U.S.? For each of the funds in your Thrift Savings Plan, the expense ratio is a minuscule 0.03%.
Go low, if you can. Choose funds with the lowest expense ratios. Those are usually index funds, though larger plans may have actively managed portfolios with rock-bottom fees. A good benchmark: Look for U.S. stock funds with expense ratios below 0.5%, bond funds below 0.4%, and specialty funds (such as international funds) below 0.8%. If you have an IRA or a solo 401(k), where you can get a wider selection, index funds are your lowest-cost option.
Look elsewhere, if you can't. Should your employer's funds be too expensive, invest only enough to take full advantage of any match. Then put the rest of your money—up to $5,500, if you're under 50—in a Roth IRA, an individual retirement account that not only grows tax-free but also lets you withdraw earnings tax-free after age 59 1/2. Your ability to contribute to a Roth, though, starts phasing out once your income exceeds $184,000 for married couples filing jointly ($117,00 for singles). If you max out a Roth or can't save in one, try a traditional IRA, which lets your money grow tax-deferred until retirement time. But first look at your W-2—and your spouse's, if you're married—to see whether box 13, labeled "retirement plan," is checked. No checked boxes? Your contribution is deductible. At least one checked box in the house? Deductibility phases out at $61,000 if you're single, $98,000 if both spouses participate in a plan, and $184,000 if only one is covered.
If you don't qualify for a deduction, you can save in a taxable account that holds tax-efficient investments—those that generate few short-term gains or dividends. Your best bets are index funds and municipal bonds.
Alternatively, if you're in a high-cost 403(b): Once you've gotten your match, contribute to your 457 plan, if available. A 457, offered by about 15% of employers with 403(b)s, may have better choices, says Scott Dauenhauer, a financial adviser in Murrieta, Calif. In a bad Simple IRA? Ask if the plan has a designated financial institution. If not, you can direct your savings to the fund group you want, says Louisville planner Andrew Sloan.
Part two: Two Easy Ways to Get Just the Right Mix of Stocks and Bonds
Part three: 3 Totally Realistic Strategies for Boosting Your Retirement Accounts
Part four: The Right Way to Roll Over Your Retirement Accounts
Chart: Your Retirement Plan Options at a Glance