Is a 401(k) the Best Way to Save for Retirement?
Upon entering Corporate America, my HR director stressed the importance of participating in my 401K to save for retirement. She said if I max it out every year and save diligently, I’ll have $2million saved for retirement with no worries. She said it was the best way and how most of America will create a comfortable retirement.
What she forgot to mention was the gut-wrenching dips and uncertainty in the stock market, the 1-3% fees I’ll be paying to the 401K administrator and mutual fund managers for the next 30 years, and the future taxes that will eat up a large part of my retirement savings. What If I want to buy a new car, take an extravagant vacation, or remodel my house – I’ll have to pay a 10% penalty and income tax to use the money from my 401K before I am 59.5. Let’s look at these 401K disadvantages in more detail.
With our current national debt over $14 Trillion dollars and no end in sight to government spending, many people feel that taxes will only be higher when they are ready to access their 401Ks. Income tax rates are currently pretty low for our country. The top rate is 35% today, but the Internal Revenue Code of 1954 had the top tax bracket at 91%. There is a good chance that tax rates will be much higher when you are ready to access your 401K. In later years, people often lose many of their largest tax deductions as the house may be paid off and the kids will be grown. Therefore, a third or more of your retirement savings in your 401K may be lost to taxes. Yes, you received a small deduction on taxes when you put money into your 401K, but you may have a huge tax bill on the principal and all of the interest earned when you access your 401K. A common question many financial planners ask is, “would you rather pay tax on the seed or the harvest”. If it was me, I’d rather pay lower taxes on the small amount of money I am saving for retirement (seed) and then after years or decades of interest and growth, be able to access all of that money (harvest) with no worry about what the future tax rate will be!
STOCK MARKET PERFORMANCE
In regards to the dips and uncertainty of the stock market, a lot of people don’t take into account the havoc these losses play on their actual money in the market. Many people feel confident that even with the volatility in the market, it has averaged 8-10% over the years depending on who you ask. The flaw in the entire discussion is that the performance of “the market” doesn’t matter; what matters is the performance of the money in your stock portfolio. If the market goes down 50% one year and up 50% the next, then some would say the average of the market is 0% so you didn’t earn anything, but you didn’t lose anything. The problem is that if you look at the actual cash in your portfolio, then you actually did lose something.
Let’s say that you invest $10 in the market and it goes down 50%. You now have $5 in your portfolio. The next year, the market goes up 50%, so your $5 becomes $7.50. So even though the market averaged 0%, your portfolio is down 25% in actual cash. You have to remember that when you lose money in the market, it takes more of a gain to get your cash back to where you started. Here are some numbers to illustrate this point:
- A loss of 20% takes a gain of 25% to get back to even.
- A loss of 30% takes a gain of 43% to get back to even.
- A loss of 40% takes a gain of 67% to get back to even.
- A loss of 50% takes a gain of 100% to get back to even.
To sum this up, “0 is your hero” or “you win when you don’t lose”. Wouldn’t it be nice if there was a way to participate in the upside of the market without ever participating in the downside? Why gamble with your future? I’ll tell you how to do this in the next post.
FEES & EXPENSES
As you build your retirement nest egg in your 401K, you might be surprised to learn that hidden fees are leaking from your plan without your knowledge. The disclosed fees are relatively easy to spot and can be found by looking at the expense ratio if your plan invests in mutual funds. These fees are commonly referred to as management fees. Administration fees are the fees that most participants don’t know about. They are in addition to the management fees, but much harder to find. One place to check is your transaction history for removal of partial shares. If you see a transaction that doesn’t look familiar, you can bet that the shares are being removed as part of an administration fee. You can also ask your HR department. Most companies need to report the expense of employee benefit plans to The Department of Labor in an annual Form 5500 filing. Your employer had to negotiate a package with the 401K provider so you probably will not find out if they chose the least expensive plan and therefore you may never know how much of your retirement money is being eaten up by fees.
CONTROL & FLEXIBILITY
You may be saving money in your 401K for 10, 20, 30 years or longer. What if you need to use some of that money before you are 59.5? It is your money, isn’t it? The fact is that you have to pay a 10% penalty and income tax on any money you want to use before age 59.5 (there are a few exceptions for “hardship withdrawals”). Pay a penalty to use your own money!? In addition, you have to start taking withdrawals of the money when you are 70.5. What if you don’t need the money when you are 70.5? You must take it or the IRS can impose a 50% tax penalty in addition to the regular federal income tax on the distribution. Why does the government require you to take a minimum distribution at 70.5? Because they want to make sure they collect taxes on that money whether you need it or not. You are also limited to how much you can save in a 401K -$16,500 for 2011.
Hopefully, you can see why the 401K is often called the 201K and why depending on the 401K for retirement is risky, puts you at jeopardy of future income tax rates, market volatility, unknown fees, and takes away any flexibility or control. Is this going to help you personally or the government (future tax income) more?? Contributing to a 401K is definitely better than doing nothing, but you might want to look at other options for saving more than the minimum to get your company match. The next post will show you a great option with more benefits and much less risk than a 401K.