The Good, the Bad and the Ugly of 401(k) Plans

— -- Many middle-class Americans—and even some with high incomes—feel that no matter what they do, they can’t build wealth because the obstacles are too great.

The good news is that you can accumulate wealth much faster than you think by making sound investments that lead to compounded investment returns—essentially, returns on your investment returns, and returns on these returns, and so on. With compounded returns, it’s astonishing how fast your wealth can grow.

The key to sustaining good returns is to avoid investing mistakes that prevent returns from growing at a compounded rate. In this regular column I will show you how to ensure that compounding is sustainable, enabling you to build wealth over time by avoiding preventable errors.

All too often, people make investing mistakes in their 401(k) plans. This is easy to do because, although these plans can be highly beneficial tools, many are deeply flawed and saddle the average investor with burdensome costs. What’s more, the typical 401(k) plan contains no offerings beyond mutual funds that may deliver poor performance. Often, the result for workers is poor net returns — what they’re left with after paying fees and expenses. This is truly unfortunate, because these plans are the main way that most Americans invest for retirement; many have no other retirement aside from meager Social Security benefits.

However, there are steps you can take to make the best use of your plan to get far better results. If you take these steps to manage your plan investments optimally, you can keep your compounding train rolling. For example, under current rules, a 30-year-old earning $55,000 a year, getting a raise each year of 3 percent and contributing 6 percent annually (pre-tax) to his or her 401(k) -- with an employer match of 50 percent, an annual return on investment of 6 percent and making accelerated contributions allowable beginning at age 50 -- could accumulate $1,067,716 by the age of 65 (assuming no withdrawals are made from the account).

These are the kind of results that Congress envisioned in 1974 when it passed legislation enabling 401(k) plans. This legislation, the Employee Retirement Income Security Act (ERISA), was intended to make investing for retirement easier and more profitable for the average person.

ERISA allows individuals to defer taxes on certain retirement plans, including 401(k) plans, until they take the money out during retirement, when their tax rate is expected to be significantly lower. These plans discourage participants from dipping into their accounts before retirement by imposing penalties for early withdrawal that apply until they are 59½. Section 401(k) of the act enabled employer-sponsored plans that workers may contribute to through payroll deduction, as well as employer matching contributions up to a point.

This was a great idea for various reasons, including the following:

Because people contribute to their plan accounts from their paychecks, they never see this money, so they can’t spend it. Out of sight and out of mind, this money goes into investment products chosen from the plan’s offerings.

Contributions are tax-deferred, so they lower employees’ tax bills. Tax on these contributions and the returns generated by investment isn’t due until money is taken out of accounts. The idea is to make these withdrawals during retirement, when most people are likely to be in a far lower tax bracket than when they’re working.