WHY YOUR 401(K) COULD BE QUIETLY COSTING YOU THOUSANDS — AND WHAT YOU CAN DO ABOUT IT

To download a PDF version of this report, please click here.

Why Your 401(K) Could Be Quietly Costing You Thousands — And What You Can Do About It

A while back, I’m guessing you made a pretty wise decision: You started saving for retirement by contributing to an employer-sponsored retirement account. Regardless of what type you had — a 401(k), a 403(b), a SEP, or another type of plan — you took advantage of some powerful tax benefits and maybe an employer match as well to add thousands of dollars… even hundreds of thousands… to your portfolio.

However, if you still have retirement accounts with former employers, you may actually be losing thousands of dollars compared with what you could have if you had initiated a tax- and penalty-free rollover to an IRA.

Because you potentially could have a wealth-devouring mix of higher costs, bad investments, and limited choices, and general Wall Street greed might be enriching other people’s retirements… at the expense of yours.

Of course, while you’re still working for the employer, you often have to keep the money in the plan. However, many plans permit current employees to roll money over to an IRA via a so-called “in-service distribution.” There might be restrictions, such as the employee must be age 59½ or older. But it’s worth asking your HR department about.

As for accounts with former employers, there’s no doubt about it: You can roll over that money to an IRA without paying any taxes or penalties. Here are four reasons why doing so could add tens of thousands of dollars to your portfolio.

1. 401(K)S Aren’t Free

Your boss deserves a lot of credit for offering a retirement plan. Here’s why…

The whole enterprise adds to the workload of the accounting and HR departments. Plans are subject to regulations from the Department of Treasury, the Department of Labor, and the IRS. They must be regularly audited. And reports must be sent to the proper authorities, as well as made available to employees.

This all costs money. And in three-fourths of plans surveyed by the Investment Company Institute (ICI), employees share in those costs. That percentage goes up for former employees, since they’re often charged fees that the boss is willing to cover for current workers.

These costs range from less than $200 annually per participant to more than $500, depending on the size of the plan. The bigger the plan, the lower the expenses per employee… since the costs are spread over more accounts. That’s money you would not have to pay — year in and year out — if you rolled the assets over to one of the many IRA providers that don’t charge annual fees or waive them for investors with a certain level of assets.

2. Limited Choices

The typical 401(k) offers a menu of 20 mutual funds. Don’t like your choices? Too bad. Want to buy individual stocks, bonds, CDs, ETFs, or other funds? Too bad. You’re stuck with the investment options that someone, somewhere put in your plan. While plan trustees are held to a fiduciary standard, the choices they make may not be the ones that you would.

Now, a very small minority of plans offer a brokerage account within the 401(k), which allows for a lot more investment flexibility. But they also often charge higher commissions and fees than the typical discount broker.

3. Poor Performance

A menu of 20 mutual funds might be fine for many investors… if they were great investments.

Unfortunately, most are actively managed funds. You know, the kind that pay a team of managers and analysts to pick the best stocks for the fund. Unfortunately, these well-educated and well-paid people usually don’t get the job done. According to Vanguard, less than one-quarter of actively managed equity funds have actually outperformed a relevant benchmark (such as the S&P 500 index) over the past 20 years.

Put another way, the investors in the other 75%-plus of funds would have been better off just investing in the benchmark itself. This can be easily done via an index fund, which does nothing but copy-cat an index, and charges very low fees in the process.

Those fees are among the chief culprits when it comes to active funds’ underperformance. They cost, on average, almost 10 times more each year than index funds. Plus, 20% of the fund assets in 401(k)s charge some kind of sales commission or annual marketing fee, according to the ICI.

Fortunately, most retirement plans offer two to four index funds. But that still means that the majority of funds in a 401(k) are actively managed. According to a joint report from the ICI and Brightscope, just 23.1% of 401(k) assets are in index funds.

We don’t mean to disparage all actively managed funds. There are plenty of really good ones. But if your 401(k) offers a menu of mostly actively managed funds, you might find better investment options in an IRA.

4. Making You Money May Not Be The Main Motive

Employers hire companies (formally known as “trustees”) to handle the nuts and bolts of operating a 401(k) — e.g., record-keeping, sending out statements, making sure the money that is taken out of employees’ paychecks gets invested. That company can be a bank, a brokerage, a mutual fund company, or some other financial services firm. That company likely also makes the decisions about which funds go into the 401(k).

Unfortunately, while trustees have a fiduciary duty to the members of their plans — which, as a reminder, means they are legally obligated to act solely in their members’ interests — in the cases when the trustee also happens to be a company that sells mutual funds, there’s evidence that some might be showing a bias toward their own funds. A study from the Center for Retirement Research at Boston College found that such trustees boot out 25.5% of underperforming funds from other companies, but just 13.7% of dud funds from their own company. The study also found a tendency of companies to add their own funds relative to other options.

Here’s a funny story: Current and former employees of Fidelity — the largest provider of retirement plans in America — sued their employer for including too many higher-cost Fidelity funds in their 401(k), as well as charging too much in other fees. Think about that: People who work for the biggest player in the retirement-savings marketplace found fault with their very own plan. The suits were settled in 2014 in favor of the employees.

Putting A Price On Sticking With Your Ex-Employer’s Plan

Let’s consider how much less someone could have if they kept their money in their old plan rather than rolling it over to an IRA, based on the following assumptions:

• The investor starts out with $250,000 in the account.
• The pre-expense return of the portfolio is 10.1% a year, which is the annualized return of large-cap U.S. stocks from 1926-2014, according to Ibbotson Associates.
• The assets are invested 23.1% in a large-cap U.S. blend index fund that charges 0.17% annually.
• The rest of the money is invested in actively managed U.S. large-cap blend funds, which underperform their benchmark by 1.12% a year (as such funds did over the 10-year period ending on Dec. 31, 2014, according to Vanguard).
• The plan charges $300 annually in administrative costs.
• The investments in the rollover IRA consist entirely of index funds, which also charge 0.17% annually and earn a pre-expense return of 10.1% annually. The account doesn’t charge an annual fee.

And the verdict is…

I don’t know about you, but having an extra few tens of thousands of dollars (maybe even hundreds of thousands!) looks pretty appealing to me.

Of course, your mileage will vary, depending on your old plan and the size of your account. You might have contributed to an above-average 401(k)… or one that really stinks.

Also, we assumed that the money in the rollover IRA was invested in index funds. However, recall that the biggest benefit of a rollover IRA is that your investment options expand from 10 or 20 to thousands, including individual stocks. And with some savvy selection, you personally might be able to do even better than index funds.

The views expressed are those of the author, Robert Brokamp, and do not necessarily reflect the views of Motley Fool LLC, Motley Fool Wealth Management LLC, or any of their affiliates. They are subject to change, and no forecasts can be guaranteed. The comments may not be relied upon as recommendations, investment advice, or an indication of trading intent. We recommend that you consult with your financial advisor prior to making any changes with respect to your retirement account.