Gone are the good ole days of working for a company for thirty years, then retiring with enough pension income that you won’t need to worry about running out of money. Now it rests squarely on your shoulders to set yourself up for retirement. Now you are lucky if you work for a company that provides some sort of matching benefit qualified plan, profit sharing plan, stock plan, deferred compensation plan or otherwise. The most common of which is the “401(k).”
Don’t get me wrong. 401(k)s help millions of people put back money for retirement. The benefits?
#1…It helps many of these same people put back more money for retirement. Why? Because a Traditional 401(k) is pre-tax. This means you don’t have to pay Uncle Same income tax on the dollars you save for yourself at that time, which gives you more dollars to save for yourself.
#2…It is the primary vehicle in this country to support the #1 wealth builder—TMV! This means “Time Value of Money.” Meaning the longer your money can be invested and investment returns can grow - not only the money you put in, but on the money earned previously on what you put in. Consider Amy and John. Amy starts contributing $500 a month to her 401(k) at age 25. John waits. He doesn’t start until age 35. In order for John to have the same amount of money as Amy at 65 investing the same way has, anticipating an 8% return, John will need to contribute almost $1,200 per month. This is more than double! *
#3… There is often a company match or other benefit. This is 100% return on your investment up to this amount! Imagine Amy’s company matched 3% of her income as long as she put 3% in her plan. When she retires, the company matches will have increased her retirement account balance by 25%! Assuming she makes $50,000 a year and never sees a pay increase, this will amount to over $400,000. *
Where is the danger in that, you might ask? Well, there is a short answer and a long answer. The short answer is the loss of flexibility…in several ways. The long answer…
#1… You may not be able to get to your money when you need it. A 401(k) is often even stricter than an IRA. You may incur pre-payment penalties, taxes, or not be able to access it at all before age 55, 59 ½, or later. You can take small loans against it, but that is a topic for another day. The bottom line—accessing those funds would be a last resort.
#2…Your investment options are typically limited to the investment funds in the plan. This may not be a bad thing, but it may not be a good thing. It depends on your future and goals, present situation, and the funds themselves. Often these funds have higher expense ratios and the options are very limited.
#3…You pay more. 401(k) plans are usually more expensive than investing outside a 401(k). There are a lot more people that need to get paid. There are administration fees –trustee, audits, taxes, plan administrators, etc. There might be service fees and there will be the investment fees.
#4…Uncle Sam will get paid. You are forced to start withdrawing required minimum distributions at age 72. This means there will be a distribution hitting your tax return as income. In the old days, your taxes were usually lower in retirement, but today we are finding that is the case less and less. Furthermore, where do you think tax rates are headed? Up or down? If you don’t have a plan to exit your 401(k) it could negate all the hard work you gave to saving those pennies. Even worse, if you and your spouse (if applicable) die, your heirs will have to pull this out over ten years. Since tax rates go up as income goes up, imagine your kids having to stack 10% of your IRA and 401(k) values on their existing income this year. What would they pay to Uncle Sam and what would they keep?
#5… Loss of Tax Diversification…This goes hand in hand with #4, but not exactly. Too many retirees are retiring with their 401(k) as their largest retirement asset. This may be okay if you simply want to turn on a distribution that resembles a taxable pension income. However, what about that remodel at the lake house? Where does that money come from? What about the RV you want purchase or the lifetime trip you want to take? If those have to come from the 401(k), you are paying tax on every penny, which could increase the cost of these goals by as much as 37% today! And believe it or not, there is even more to this story. Where will the money come from to pay the taxes? If it is from the 401(k), you will be paying taxes on taxes! Imagine a $10,000 tax bill that will cost you another $3,700 to pay. Then you will face another 37% tax on the $3,700 and on and on we go!
Canadian Businessman Craig Bruce said, When shooting in the dark, it is a good idea to us a machine gun. A 401(k) by itself is the furthest thing from a machine gun. There is no cookie-cutter answer to solve what is best for you, your future, and your family. The bottom line is this. You need a plan!
*Assumed 8% return, compounded monthly. There are no stated or implied guarantees. Past performance is not indicative of future results.