For a lot of working Americans, their company’s 401(k) plan is their #1 investment vehicle for retirement planning. Since they started working, they’ve been told to max out their 401(k) account each year and when they are ready to retire, they will have enough money to live on.
People have followed this advice. According to the Investment Company Institute, more than $5 trillion sits in these accounts with more than 54 million American workers as active 401(k) participants.
Of course, retirement wasn’t always like this. Before the 401(k) was invented, which is now only 40 years old, people had a pension plan to fall back on. You would dedicate your entire life to working for a good employer. When you retired, the monthly pension you received would take care of you.
401(k)s were not built to replace pensions
As Time points out, the 401(k) wasn’t built to replace this system of pensions:
- To be fair to section 401(k)’s framers, the provision was never intended to be a broad-based saving incentive that would serve as a foundation for financial stability in retirement. Instead, it marked a truce between the IRS and firms that wanted to let employees plow
their year-end bonuses into pension plans. The IRS sought to tax employees immediately on those amounts, on the theory that the pension plan contributions were equivalent to cash. Congress struck a compromise, whichit tucked away in a provision of the 1978 Revenue Act that garnered little notice at the time: employees could delay taxes until they withdrew cash from the plans, as long as the plans satisfied certain statutory criteria (including a requirement that the plansnot discriminate in favor of the firm’s highly compensated employees).
Fast-forward 40 years later, you have to look hard to find a company that still offers a pension. Meanwhile, it seems like 401(k)s are everywhere…at least for people that work for large companies. People that work for smaller companies are out of luck.
Is the 401(k) is a horrible retirement plan?
Not everyone is a believer in the 401(k).
In fact, some people think the 401(k) is not in their best interest.
Andy Tanner, the writer of 401(k)aos, shares with you why your 401(k) or similar accounts could be killing your chance of a dream retirement.
You can get a free copy of 401(k)
What are some of the negatives about a 401(k)?
For starters, you have no control over your money in a 401(k).
Unless you are invested in a self-directed 401(k), you literally hand over your money to an investment manager and hope your account grows.
Do you want access to your money?
Sorry. You won’t be able to access your money before the age of 59 ½ without paying a penalty. Although you are allowed to borrow from your 401(k), the money has to repaid with interest.
What if the market crashes?
Too bad. You better hope the market rebounds so you can recoup some of your losses. Unlike other investments such as real estate, there’s no insurance plan for a 401(k).
You also are capped on the amount you can invest.
As of 2019, if you want to invest more than $19,000 a year, you’re out of luck and need to find another investment vehicle.
Another really bad thing about 401(k)s is that the fees from so-called “managers” has gotten out of hand and cut significantly into your earnings.
Finally, there are significant tax disadvantages to investing in 401(k)s. Rather than taxed at the lower capital gains rate of around 15%, they are taxed at earned income rates, which can be twice as much.
What’s good about a 401(k)?
With so many negatives, is there anything good about a 401(k)?
Yes, there is.
It’s a lazy way to invest your money, and no one has come up with a better idea that can work on a large scale for the masses of investors.
The problem is that most people who invest in 401(k)s don’t know a lot about money or investments. Most people don’t have the time to study annual reports and poor over financial statements in search of a value stock.
Therefore, many investors are happy to give away their money, even if they could be putting it to much better use in other investments.
The problem is, there’s no such thing as free money. The money you expect to receive from your employer match (which most believe is free money) is yours anyway and could be invested someplace else.
Here’s what I mean.
Let’s say that your employer matches up to 4 percent of your salary if you invest in your company’s 401(k). That sounds great. It’s a hundred percent return on your money. And it’s free money, right?
Not really.
If it weren’t for 401(k)s, your employer would have to pay you that money as part of your salary in order to remain competitive. Otherwise, the best employees would migrate to better-paying companies.
As it stands, the better companies still pay it, but only if you give up four percent of your existing salary into a retirement account where you have no control.
If you don’t, your employer gets to keep the money. The reality is that if you’re investing in a 401(k), you’re not getting free money because of your employer’s match. You’re simply getting what is owed you by your employer.
Does a 401(k) steal your money?
There is actual research that shows that 401(k)s actually limit the salary you could earn.
According to Steven Gandel, a study issued by the Center for Retirement Research indicates that, “All else being equal…workers at companies that contributed to their employees’ 401(k) accounts tended to have lower salaries than those at companies that gave no retirement contribution…In fact, for many employees, the salary dip was roughly equal to the size of their employer’s potential contribution.”
Translation, companies that don’t offer 401(k)s must pay a higher salary to compete with companies that do. Those company’s employees simply get their money as part of their salary rather than having to match it and save it in a tax-deferred retirement plan where they have no control and have high fees.
Stick with the 401(k) if you have limited financial intelligence
Control is an important aspect of investing.
With a 401(k), you have no control over your investments as you generally invest in funds and indexes controlled by brokers.
If you want to become wealthy, you must have a financial literacy and control over your money and your investments. The less control you have, the lower your potential return. This is why the 3 Pillars of Investing: investing in your own business, purchasing real estate, and investing in passive income streams can offer higher potential return.
Obviously, it takes a great deal of financial literacy and intelligence to invest in things where you have control because you have to make a lot of important decisions to make.
If you lack the time and resources to gain financial literacy, then being forced into a 401(k) probably isn’t a bad thing. You wouldn’t know what to do with the extra money other than to
Final thoughts about 401(k)s
The 401(k) is not 100% bad nor is it 100% good. With most things, there are positives and negatives.
Nonetheless, since its inception, the 401(k) has proven to be an important instrument to help you prepare for retirement. If you have the option to invest, I believe it should definitely be used for retirement planning.
However, I still admonish you to not put all your eggs in one basket. I discussed the reasons why you should diversify by also investing in real estate and other asset classes in a previous post.