ETFs For Your 401(k)?

By Denise Appleby AAA

Investor ownership of exchange-traded funds (ETFs) has grown significantly over the last decade as more investors became aware of their relatively low costs and tax benefits.

However, most of this growth has occurred outside of retirement plans. Seeking to allow participants to hold this increasingly popular asset in their retirement portfolios, some retirement plan practitioners are exploring the practicality of offering ETFs in an area of investing once dominated by mutual funds. Read on to learn about how ETFs can fit into your retirement plan.

SEE: An Inside Look At ETF Construction

ETF Trends
ETFs have experienced exponential growth, largely attributed to features that allow the investor to enjoy the diversification associated with investing in stocks, and fees that are typically even lower than those that apply to mutual funds. However, despite their increasing popularity, not everyone thinks that ETFs would be a good fit for all types of retirement savings portfolios.

The Discussion
Many retirement practitioners agree that ETFs are better investments than mutual funds for non-retirement assets in most cases. The fees are typically lower, they can be traded like stocks and they may not trigger capital gains for in-kind trades. However, these features may not be ideal for tax-deferred retirement plans, as retirement plan assets are usually traded infrequently, and assets are taxed as ordinary income when distributed, regardless of the period for which the assets were held. On the other hand, they may be suitable for retirement plans where assets can accumulate tax free, such as Roth IRA and Roth 401(k) plans.

ETFs may seem like a good fit for a Roth 401(k), however fiduciary-related issues must still be considered. A plan sponsor must ensure that the required options for diversification are satisfied (if the plan allows participants to direct investments), and that the investment education requirements are met. Plan sponsors who are not already working with a fiduciary advisor may consider engaging the services of an accredited or certified fiduciary analyst to review the plan's investment options and ensure they conform to fiduciary standards.

Why Roth 401(k)s May Work with ETFs
Background
The designated Roth contribution program was introduced under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), effective for tax years beginning Jan. 1, 2006. The program allows a plan sponsor to include a feature where employees may designate a portion or all of his or her elective contributions under the plan as designated Roth contributions.

Similar to Roth IRA contributions, designated Roth 401(k) contributions are made on an after-tax basis, which means that they are not subject to income tax when distributed. Earnings are also tax-free if distributions occur at least five years after the year the first designated Roth contribution was made to the participant's account, and one of the following applies:

  • The distribution occurs on or after the participant reaches age 59.5.
  • The distribution occurs because the participant becomes disabled, as defined under the plan.
  • The distribution is taken by the participant's beneficiary after the participant's death.

It is this potential for tax-free distributions that makes ETFs attractive to participants, especially those who feel they will be in higher tax brackets during their retirement years.

ETFs in Roths Will Work Only if Roth Makes Sense
If you are the plan participant and your employer offers a designated Roth 401(k) program, the employer must also offer a traditional 401(k) plan. As such, you will need to decide which is better for you. Roth 401(k) contributions are usually more suitable for individuals who will be in a higher tax bracket during retirement, as the tax-free growth allows them to avoid higher taxation on their retirement savings.

Working with a competent financial planner to estimate your retirement income during retirement will help to determine your tax rate during retirement - assuming tax rates remain the same as they are today. If you have many years until retirement, it is more challenging to make a realistic projection, as assumptions must be made about how much you will earn over the years and your tax rate for those future years. However, where there is any doubt, you can enjoy the features and benefits of both types of 401(k) plans by splitting your contributions into both types of 401(k) programs.

SEE: Will Your Retirement Income Be Enough?

Fees Should Be a Factor
If you are permitted to choose between ETFs and other forms of investments, you not only need to work with a financial planner to ensure that the chosen investments suit your financial profile, but you should also consider how any fees may affect your net value. Some experts suggest that the low cost of ETFs may be outweighed by the commissions and other trading costs that can be racked up with frequent trading. Further, while most ETFs cost less than most mutual funds, there are a few that may be more costly. For instance, index funds may cost less than some ETFs. Ask about the fees that apply before you make an investment choice. You can start your research by using the FINRA Fund Analyzer to compare the expenses of up to three exchange traded funds, mutual funds or share classes of the same mutual fund. For accounts with small balances, it can take a few years to recoup the set-up and administrative fees.

The Bottom Line
Merging ETFs and retirement plan assets is a fairly new concept, as ETFs have traditionally been held in after-tax accounts; therefore, all aspects must be considered before choosing this investment. This includes fees at the plan level, fees at the participant level and whether the offerings satisfy regulatory requirements for diversification. From the plan sponsor's perspective, fees may be reduced by doing omnibus trades instead of having participants trade individually. From a participant's perspective, if the choice is between putting the assets in a Roth 401(k) or an after-tax account, the Roth 401(k) is the better choice, because tax free is better than capital gains treatment. If the Roth account is self-directed, the same trading pattern that can occur in a non-retirement account can occur in the Roth brokerage account. In other cases, an extensive retirement analysis should be done to determine which is most suitable.

comments powered by Disqus
Related Articles
  1. Emerging Market Bond ETFs: Look Under ...
    Mutual Funds & ETFs

    Emerging Market Bond ETFs: Look Under ...

  2. Playing Penny Stock-Like ETFs
    Stock Analysis

    Playing Penny Stock-Like ETFs

  3. How Low-Volatility ETFs Can Enhance ...
    Investing News

    How Low-Volatility ETFs Can Enhance ...

  4. Impact Of Continuing To Work In Retirement ...
    Retirement

    Impact Of Continuing To Work In Retirement ...

  5. Independent 401(K): A Top Retirement ...
    Retirement

    Independent 401(K): A Top Retirement ...

Trading Center