Smart Advice for the HuffPost Investor: A "No-Brainer" to Invest in Your 401(k) Plan? What if Everyone is Wrong?
(The following is an edited excerpt from my new book, The Smartest 401(k) Book You'll Ever Read, used by permission, Perigee Books/Penguin Group [USA] Inc.).
With 401(k) assets plunging as the markets continue their downward spiral, employees are looking at their 401(k) statements with a sense of dread. Few, however, challenge the conventional wisdom that investing in these plans is a "no brainer" because of the employer match.
I agree with most advisors who believe the corporate match of a 401(k) and 403(b) plan is too good to pass up. Investors probably should contribute to these plans - at least the minimum amount necessary to obtain the maximum employer match. However, I'm more concerned than most about future developments that could make any investment in retirement plans a bad choice.
I don't know about you, but I find the government to be pretty scary. Recent events have demonstrated that it has very broad power to have a serious impact on our rights.
The possibility of retroactive legislation that could sharply reduce, or even eliminate, the benefits of current retirement planning cannot be discounted. The ability of the government to pass retroactive tax legislation going back as much as ten years has been sanctioned by the Supreme Court, which has referred to this disturbing conduct as "customary practice."
Don't take my word for it. In its brief to the Supreme Court supporting the power of the government to take away your money retroactively, the Justice Department had this chilling observation: "The taxpayer must be prepared for such possibilities."
Are you prepared for the possibility that the government could retroactively impose a new tax on distributions from your retirement accounts? It could happen. If it does, it could seriously erode the benefits of participating in these plans.
In addition, looming darkly over your retirement planning horizon is the uncertainty of the ordinary income tax rate at your retirement. It cannot be predicted or quantified. What we do know is that by investing in a tax-deferred plan you have surrendered your right to be taxed at the historically more favorable long term capital gains rate.
Even if tax rates stay the same, it's by no means a foregone conclusion that your post-retirement tax rate will be lower than your pre-retirement rate. Here are some variables that could adversely affect your tax rate:
You are likely to be single at some point in retirement. If so, your status as a single filer could put you in a higher bracket.
You may decide to work in retirement, to supplement your income or just because you may find it satisfying to do so.
You may not have the same tax breaks in retirement that you presently have -- like your deduction for mortgage payments.
When you add to these potential problems the lack of liquidity of retirement plans, the limited and often poor choice of investment options available to plan participants, and the high fees buried in these plans, you begin to question the unbridled enthusiasm of financial planners and the financial media for investing in these plans.
I fully understand the hype. These plans are great for employers, for the mutual fund and insurance industries, for brokers and for annuity salesmen.
There are ways to maximize your retirement savings within these plans. I discuss them in my book. If Congress served the needs of its constituents, instead of the powerful lobbyists for the securities and insurance industries, it could easily legislate the changes that would provide much needed disclosure and protection to plan participants. Nothing would make me happier than to make books like mine unnecessary.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.
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I read the first 24 chapters of the book at the bookstore today. Relax, they are very short. The major points I have picked up so far: 1. be sensitive to the fees you are being charged, use Vanguard index funds as a benchmark 2. complain to management if the fees are too high 3. if you don't save enough while working, your retirement will not be very enjoyable, the average 401K balance according to a survey mentioned in the book is about $65,000, with a median of around $19,000.
If you are a novice at investing, this book would be a good place to start to pick up some useful pointers. As the book points out, Federal regulators could do a better job requiring plan sponsors to better disclose the fees being charged to each account. Unfortunately, the investment industry is filled with self-serving individuals and businesses. It's up to you to understand your 401K plan.
Although 401Ks have transferred investment risk from employers to employees, in one respect, the 401Ks are much better as the vesting times are much shorter for 401K plans than they were for the old fashion pension plans in the 1970's or early 1980s.
NCGigi has the right idea. S/he said:
Pay off your mortgage, plant a garden and some fruit trees. This is retirement security.
It would also be a good idea to save enough to make payments for at least 6 months, if you can. A year would be better. You can't always count on being able to get money out of the 401k, but usually you can.
One thing that many don't consider is when you take money out of a 401k you pay regular taxes on every penny you pull out. You don't get capital gains. If you and your wife are drawing $20,000 in Social Security, and if you draw out over $12,000 it will push you into having to pay taxes on your Social Security. You pay taxes when your income reaches over $32,000.
Social Security is more valuable for retirement than most 401ks. Figure up how much money you would have to save to draw $20,000 interest a year or whatever amount you expect to draw from Social Security. Part of that is earned by paying in a surplus and it drawing a decent rate of interest over 45 to 50 years.
If you put your after tax money in a savings account outside the 401k, then you won't have to count it as income after you retire, but you will have to pay taxes on the interest every year.
Money Markets in 401ks and IRAs are not insured.
Social Security is indeed a valuable asset (at least it has been up to now), but it is not sufficient to retire on by itself and was never meant to be. People who don't take advantage of 401K plans at work may not have the discipline to save on their own outside the plan. For many average people, government employment, with its better health benefits and defined benefit pension plans may be the better route. Companies who set up 401K plans with lousy, high cost options are doing their employees a tremendous disservice. In coming years, many private sector employees will end their days having to scrimp and watching their pennies. How sad.
Taking the employer match is a no brainer. It gets more complicated after that.
Your 401k money can grow tax free, which makes it better for savings than investments, unless you trade funds a lot. Outside of your 401k, you only pay taxes on the dividends. You pay nothing on growth until you sell the stock and then you get the capital gains rate. Inside of a 401k, you can control some of the charges by what you buy.
Two people can both contribute the same amount of money, but the $50,000 earner doesn't save as much on his taxes as the $250,000 income earner. That is unfair in some ways, because it takes more sacrifice for the lower income earner to invest, than it does the higher income earner.
It would be interesting to read how it works when cashing out of your 401k or IRA after retirement. So much would depend on how much you take out and how much Social Security you draw, as far as the tax rate you will pay and how much of your Social Security would be taxed.
If you cash out all at once, you would be in a higher tax bracket only one year for Social Security. Or cash it out over a two year period to stay out of the higher bracket. Or a person could take out just enough each year, so they wouldn't have to pay taxes on Social Security. I don't mind paying taxes, except for retirement.
First off contributing up to the employer match level really is a no-brainer. It is like getting 50% interest in the first year, which is an even greater boost to long-term compounded yields.
Second of all you get a bird-in-the-hand reduction in taxes NOW. So maybe later they will retroactively tax it. In the meantime you have had the benefit of the money and interest on the money and tax-free compounding on the money.
Of course it is important to keep your 401k properly diversified (avoid the company stock choice) and in low-fee funds, and with a wise asset allocation. But that is smart investment generally and nothing specific to 401k plans.
But what you point out about the uncertainty of the future is exactly why I am leary of Roth IRAs and Roth 401k plans. You are basicly betting on a promise by the government that decades from now they won't tax the distribution.
Excellent article!! This has been my point for quite some time. We don't know, cannot predict, nor control, what the tax rates for this disbursements will be in the future.
Pay off your mortgage, plant a garden and some fruit trees. This is retirement security.
Oh, come on.
When times are bad, everything that you do is the wrong thing. When times are good, everybody has a way to make them better. It's human nature.
And oh, by the way, it sells books.
Do the same thing today that you did yesterday and should do tomorrow - maximize your savings, diversify your investments, rebalance periodically, and if you want to be POTUS, don't inhale.
P.S. - it's MUCH more likely that an additional tax will be levied on high wage earners, and tax rebate systems dropped, than Congress would endanger retiree's nest eggs. Old people vote, and vote a lot.
I've never understood the mathematics behind the "you might be in a higher tax bracket when you retire" argument. Yes, the marginal tax rate may go up and you may be taxed on the additional income. But unless you're mega-rich, most of your retirement income will be taxed at a lower rate.
The fact that you "find the government pretty scary" makes me question your judgment. We do have a major say in our government, and we're not going to allow our elected leaders to throw us completely under the bus. And we've had a long tradition of protecting our retired people - to the point of working really hard to control inflation and working hard to keep the Social Security system solvent.
Anyway, if everyone's wrong, we're in a lot more trouble than a couple of minor investment decisions will remedy.
I find the debt pretty scary.
I have a wife and three kids, our share of the national debt is $150,000. Enough to wipe out all the money I have saved so far and maybe even put me in the red (I am 33). I think I'm doing well having 6 figures put away, compared to my peers (who only have that kind of assets-liabilities value if you count paper profits on houses).
How would our government pay off that debt if we had to pay the whole balance in, say, 10 years? I'm pretty sure they would have to take the savings of folks who planned ahead, cause the rest of the population couldn't take that kind of hit to their income.
Maybe I will be in another country by then though.
Your family's $ share of the national debt is a lot higher, once you include unfunded liabilities such as Social Security and particularly, Medicare. There is no way the government could realistically pay off the widely publicized national debt ($9.4 trillion) in 10 years, unless it raised taxes substantially. Then there are the unfunded liabilities I mentioned above, which far exceed the stated national debt. If it is any consolation to you, you are probably doing better than most people your age. Unfortunately, every disabled 23 year old soldier who comes back from Iraq will expect the government to look after his financial needs for the rest of his life at a cost of perhaps hundreds of thousands of today's dollars. I suspect that many people of your age group will not be able to afford to retire until their 70's and their children will have it even worse. So much for all those politicians in Washington who claim they support family values. They may dislike gay people, but they certainly have not made life any easier for families. They are leaving today's young people with a financial time bomb that could go off at any time. Blessed are the children, for they shall inherit the national debt.
it has always amazed me that lambs to the slaughter (investors) never picked up on one basic tenant in the "Big Casino". I make a dollar, you have to lose a dollar. You make a dollar, I have to lose one. And all the while the house get it's cut. Can you make money on Wall Street - hell yes, but you can also make money pitching pennies, playing craps in Vegas, on-line poker parties and sticking up banks.
Just remember there is a down side to all these endeavors.
Equities are not a zero sum game... commodity trading and option trading is.
Two words. ROTH IRA.
Control your own investments, make money, get the lump sum tax free at the back end. 401(k) investments are great if the company is matching your money, but you're chained to whatever options the provider allows, which is almost always some sort of fund (index or otherwise).
It's more work investing by/for yourself, but do the research and find good companies and you have a good chance of out-earning the markets.
401(k) plans are the invention of investment banks. What self respecting market Republican would tolerate a "government" tax benefit to induce people to save for their retirement? The spigot of cash on a monthly basis flowing into mutual fund managers is beyond phenomenal! And look at the "growth" of the stock market since the inception of the 401 (k) spigot of cash. When the spigot begins to flow the other way, what impact on "value" (that exoterica that eludes the idle-minded American) you might ask. This stock market business is all equity financing, a breed of cat that has nothing to do with ownership and everything to do with the free use of others' money.... even with a government subsidy!!! Wow... and you have nitwits who write about "subsidy" to farmers... which amounts mostly to food stamps that are no direct aid to farmers.
The market is a more complicated breed of ponzi scheme. When the shit hits the fan.... there is (for the most part) no there there.
A self respecting Republican. Go on now.
I was before they twisted it into something I no longer recognize. Sad.
I love it!!! I usually disagree with you to a large extent but this is spot on. The first thing I did my first year not working was start draining my 401k. The best part was the reaction. It was almost as if the firms actually, for once, were acting as if they were concerned with their fiduciary responsibility in informing me of my reckless stupidity in taking it out. "Thats tax free growth", "You will be penalized 10%" (I'm relatively young). And on and on it went. From a bunch of people that I wouldn't have allowed to bring coffee to my trading desk. I politely explained that I got a 100% matching on this money, avoided an almost 50% tax on my dollars in, and even with a 10% penalty I am now getting $1.80 as opposed to the $.50 I would have gotten without the plan. Then I would hear "but tax free forward growth" To which I would say "OK can you please tell me what you think the tax rate for someone with money could be in another 30-40 years?" My bet is really really high, now give me back my money, I want it out of the country, i have a plane to catch.
Funny how people don't see this risk.
Hmm. You and Dan are right. Run the numbers and do what they suggest.
I love it!!! I usually disagree with you to a large extent but this is spot on. The first thing I did my first year not working was start draining my 401k. The best part was the reaction. It was almost as if the firms actually, for once, were acting as if they were concerned with their fiduciary responsibility in infororming me of my reckless stupidity in taking it out. "Thats tax free growth", "You will be penalized 10%" (I'm relatively young). And on and on it went. From a bunch of people that I wouldn't have allowed to being coffee to my trading desk. I politely explained that I got a 100% matching on this money, avoided an almost 50% tax on my dollars in, and even with a 10% penalty I am now getting $1.80 as opposed to the $.50 I would have gotten without the plan. Then I would hear "but tax free forward growth" To which I would say "OK can you please tell me what you think the tax rate for someone with money could be in another 30-40 years?" My bet is really really high, now give me back my money, I want it out of the country, i have a plane to catch.
Funny how people don't see this risk.
OK. So I take it all out now and suffer the 10% early withdrawal penalty, plus pay 28-35% taxes on the total assuming its enough money to get me into the top bracket, right? And even if it's not enough by itself, adding it to my income can push the marginal rate that applies to it up. So that 50% match is basically gone, especially if I had my money in "mutual funds" that the employer limited the 401K to and inflation is considered. The market is worth the same thing it was in 2000 (if you are lucky), and there were annual fees for the funds, right? Then there's the state tax on the income too. The money is worth less than 50% of its face value after tax if it's withdrawn now. If I wait until after retirement, and am in a lower marginal bracket, it could be worth more. Won't know until I get there. The numbers don't look pretty either way.
The whole investment system has way too much influence on our economy. The favored tax status is possible only because the rich write the laws. Tax investment income the same as earned income. Then we'll see how many people are willing to gamble on securities.
"There are ways to maximize your retirement savings within these plans. I discuss them in my book."
Well...there ya go...buy the book. Huff-po as a marketing tool.
Glance through the book at your local bookstore. That's what I'll be doing. Chances are, there are no magical answers in it.
Or...order it online through the library and pick it up at your local branch. Free of charge!!
Spot on, Dan!
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