Many companies now automatically enroll new and sometimes existing employees in a 401(k) plan. The employer selects the savings rate and investment, often investing 3 percent of each worker's pay in a target-date fund unless they opt out. However, the default savings rate and investment might not be ideal for every employee, and it probably won't allow you to claim the entire 401(k) match or all the tax breaks you are eligible for. Here's why you should reconsider whether to accept your 401(k) plan's default settings.
A low savings rate. Automatic enrollment has been successful in getting more employees to save in 401(k) plans. Participation rates are 30 percentage points higher in 401(k) plans with automatic enrollment (88 percent) than in plans without it (58 percent), according to a Vanguard analysis of 1,900 401(k) plans with 3.9 million participants. Automatic enrollment has been particularly effective in getting young and low-income workers to begin saving for retirement.
However, workers who are automatically enrolled in 401(k) plans save only a very small proportion of their salary. Most 401(k) plans with automatic enrollment have a default savings rate of 3 or 4 percent (64 percent), Vanguard found. That's considerably lower than the median savings rate among all 401(k) plans of 5.9 percent. "That savings rate is likely to be insufficient for most people," says Jim MacKay, a certified financial planner for Jim MacKay Financial Planning in Springfield, Missouri. "The first thing I would suggest is to increase the deferral percentage to 10 to 20 percent."
Some 401(k) plans combat low savings rates by automatically increasing the amount workers save over time, typically by 1 percent each year. The 1 percent annual increase in the default savings rate usually continues until the worker reaches a target savings amount, such as 10 percent of pay. "If the employer allows for an automatic increase each year, we also recommend taking advantage of that," says Elyse Foster, a certified financial planner for Harbor Financial Group in Boulder, Colorado. "It will allow automatic savings increases without any additional effort."
Missing out on the match. Sticking with a low default savings rate might cause you to miss out on part of the 401(k) match your employer offers. Nearly half (47 percent) of Vanguard 401(k) plans require employees to save 6 percent of their pay in order to capture the entire 401(k) match. Depending on how the match is structured, an employee who sticks with a 3 percent default saving rate could miss out on half of the 401(k) match. For example, a worker earning $50,000 who works for an employer that provides 50 cents for each dollar saved in the 401(k) plan up to 6 percent of pay is eligible for a 401(k) match worth as much as $1,500. However, if that worker is automatically enrolled in the 401(k) plan at 3 percent of pay and doesn't take action to change his savings rate, he will only get a match of $750. "Not contributing to the level of your company's match means you are literally leaving money on the table," says Stacy Gallagher Ployhar, a certified financial planner for 2020 Financial Planning in Seattle.
Passing up a bigger tax break. You can defer paying income tax on the money you save in a traditional 401(k) plan. And the more money you save up to the annual contribution limit, the bigger the dollar value of your tax break. For example, if you earn $50,000 and automatically deposit 3 percent of your salary, or $1,500, in a 401(k), you will save $375 on your income tax bill, assuming a 25 percent tax rate. If you instead deposited 10 percent of your salary, or $5,000, in the 401(k) plan, you could reduce your tax bill by $1,250. You won't have to pay income tax on the money you contribute to a traditional 401(k) until it is withdrawn from the account.
The default investment might not meet your needs. Almost all Vanguard 401(k) plans (97 percent) use a target-date fund as the default investment. Target-date funds contain a mix of stocks, bonds and cash that is diversified and gradually grows more conservative over time. However, it's important to check out whether the target-date fund's underlying investments, the rate at which the fund grows more conservative and the fees charged suit your risk tolerance and investment needs.
If the target-date fund isn't an ideal fit, you can switch to other funds in the 401(k) plan. "We do suggest reviewing all of the available funds, paying particular attention to index funds," Foster says. "Target-date funds can have higher fees than a grouping of indexed options." Your 401(k) plan will send you an annual fee disclosure statement that outlines the costs and investment performance of each fund in the 401(k) plan. Review this document annually to see if your plan contains lower cost options to invest for retirement.
Emily Brandon is the author of "Pensionless: The 10-Step Solution for a Stress-Free Retirement."
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