401(k)s are the traditional route many hard-working Americans take to save money for retirement. However, not all 401(k)s are as beneficial as they may seem to be. When you open a 401(k), you’re essentially putting your financial trust in the fact that your employer has your best interest. Unfortunately, this isn’t always the case, which is why many individuals are seeking more ethical 401(k) alternatives.
If you’d like to learn more about why you should look into a 401(k) alternative, then keep reading.
What Is a 401(k) Plan Anyway?
In a nutshell, a 401(k) is a retirement account sponsored by your employer. It allows employees to designate a certain percentage of their pre-tax salary towards said account.
But that money doesn’t just sit in the account waiting for the day you retire—the funds are invested in a range of investment activities including stocks, bonds, mutual funds, and cash.
401(k)s are usually offered in the form of a benefit from their places of employment. Each employee can choose his or her own set percentage of their pre-tax salary, which is taken out of their paycheck and deposited in the account as an investment. The employees also have control over which investments their money is used for.
Depending on the details of the plan being offered, the money invested may or may not be tax-free (when the money is taken out) and matching contributions may or may not be made by the employer.
Of course, when the terms include tax-free investment money and matching contributions from the employer, financial experts always advise contributing the maximum amount per paycheck you can swing.
Another benefit of 401(k) plans is that they’re also protected from creditors under the Employee Retirement Income Security Act of 1974 (ERISA). That means if you have any debt or are looking to refinance a loan, they cannot take money from your 401(k) for garnished wages or take this money into an account in determining your eligibility.
Of course, while 401(k)s come with a lot of benefits, making them the popular option, they’re not the only option in the retirement plan game. There are also varying individual retirement accounts (IRAs), the most popular—but not the only—being Roth IRAs.
Traditional Vs. Roth IRAs
Individual retirement accounts are tax-advantaged accounts that can be used to invest in your retirement, which is the definition which a 401(k) technically falls under. The Roth IRA, on the other hand, is funded with after-tax dollars. This is its greatest distinction from the traditional IRAs.
With Roth IRAs, individuals are required to pay taxes on the money they contribute to the account. That money continues to grow tax-free within the account, and once the money comes out of the account, it’s virtually tax-free under certain stipulations.
For example, there’s the five-year rule.
In general, the five-year stipulates that to avoid penalties in the form of taxes or fees, an individual must wait until they’ve both reached the age of 59½ and have had the account for a minimum of five years.
This is also referred to as a qualified distribution, whereas an unqualified distribution can result in a 10% penalty on your earnings and incurred tax on the money taken out before the requirements of the account have been met.
So, if you’re under the age of 59½ or have had the account for less than five years, any withdrawals are considered an unqualified distribution. Of course, there are some exceptions to the five-year rule, but you get a general idea.
Additionally, a Roth IRA can be opened at any time in an individual’s life, granted they have a steady income. Therefore, they can make their contributions at any age and maintain their IRA indefinitely.
These contributions, however, must always be made in cash—which includes checks. Much like 401(k)s, once a contribution is made into a Roth IRA, the funds are contributed to a variety of investment activities including mutual funds, bonds, stocks, ETFs, CDs, and money market funds.
Lastly, unlike with 401(k)s and other traditional IRAs, there aren’t any required minimum distributions for a Roth IRA.
Ethical Concerns About 401(k)s and the Banks You Get Them From
While 401(k)s have become the dominant retirement plan for most U.S. employees, there is a concern of fiduciary duties being met by both employers and the banks that handle them.
Employers are legally obligated to follow the judiciary standard, meaning that they’re expected to put their employees’ best interests before anything else. However, according to a 2015 investigation carried out by FRONTLINE, ethics have been brought to the forefront of 401(k) concerns.
In essence, 401(k)s came under suspicion for making companies richer as a whole at the expense of their employees.
Here’s the deal: 401(k)s come with several fees, including administrative fees, asset management fees, and marketing fees. These fees are expressed as an expense ratio (ET). An ET a percentage applied to the full balance of an IRA, which is costing median-income two-earner families an average of $155,000.
That’s nearly one-third of an entire 401(k) investment lost.
In some cases, employers will improperly choose the shares that specifically lower their administrative fees since they must match their employees’ contributions. These are virtually the same shares that come with higher fees at the expense of the employees.
The risk of the market and the fees that come with it all fall on the employer as they choose the 401(k) contribution model for their business as a whole. After choosing the plan, there’s not much else in the way of incentive for the employer to carefully watch the market or how the fees affect each account.
In other words, when the employer falls asleep at the wheel, they end up allowing excessive fees to eat away at their employees’ contributions.
However, employers are not solely to blame for this. The financial institutions offering 401(k) plans like to entice employers by offering other services such as a line of credit or loans. Of course, when they do this they rarely make the distinction between the employees and the subsidization of corporate expenses, which results in wrongful fee allocations.
In other words, they’re tricking employers into leveraging their 401(k) business in return for cheap loan rates at the expense of the employees’ retirement funds. This is what mixing interests looks like, and since an employer is obligated to look out for his or her employees’ best interests, it’s a big no-no.
Other 401(k) Alternatives You Can Try:
Luckily, there are safer 401(k) alternatives that hard-working individuals can use to fund their retirement.
Here’s a closer look at your 401 (k) alternatives:
A simplified employee pension (SEP) IRA is a savings plan that’s also established by employers. This goes for self-employed individuals as well, and it benefits both the employer and the employee.
With SEP IRAs, employers can make tax-deductible contributions on behalf of their eligible employees. Eligible employees include individuals 21 years of age or older working for a business for at least three years. They must have earned a minimum of $600 within the past year of working.
While employees are responsible for their SEP IRAs, employers that want to receive the tax-deductible benefits must match the employee’s contributions.
These accounts are easy to set up and have low administrative costs. All contributions grow as tax-deferred, until retirement, where distributions are taxed as income.
A cash-balance plan is a defined benefit plan, similar to a pension. These plans designate that participating employees will have access to a specified lump sum upon retirement.
The benefits of a cash-balance plan depend on both employer and employee contributions and apply for each year an employee earns benefits. Those benefits are accrued via the following formula:
annual benefit = (wage x pay credit rate) + (account balance x interest credit rate).
Upon retirement, an employee can either take their lump sum or choose an annuity that pays out their some in regular checks over a period of time.
There are several types of investment accounts including standard brokerage accounts, retirement accounts, education accounts, and investment accounts for kids. The one you choose will be directly related to your savings goals for the future. Additionally, they all fall under the category of a brokerage account.
For example, you could opt for a 592 savings plan if the goal is to fund your or your children’s educational expenses.
Some of these investment accounts follow the typical IRA rules and requirements, while others are more flexible in who can contribute and when the money can be withdrawn from the account. However, they all focus on contributions and investment activity for either tax-free or tax-deferred growth that will benefit the account owner at a later time.
Are There Any Ethical 401(k) Alternatives?
Seeking an alternative to 401(k)s is a wise idea, considering the potential loss that hangs in the balance of your overall contributions. However, even with the alternatives, you’re still required to open a standard brokerage account at a bank.
The truth is, many corporate banks today use the money from the fees and interest they charge to fund disastrous projects that continue to destroy our planet. Unfortunately, that means as you contribute to your investments and future, you’re also contributing to their environmentally catastrophic causes.
It doesn’t have to be this way, though. There are ethical alternatives, such as Aspiration’s green financial services that don’t funnel their money into devastating oil projects, but instead make charitable donations to several incredible causes from human rights, environmental efforts, education, and much more.
So, when you’re ready to start investing in your future while making the Earth a little greener at the same time, reach out to us. We’d love to help you pay it forward.