Are you saving for your retirement through a company 401(k)? Is a 401(k) your main source of retirement income besides Social Security? If that is the case, there may be some flaws in this approach, as 401(k)’s have some significant flaws that need to be considered, while I am an overall fan of 401(k) plans up to a point, there is a limit to how I would endorse them. First let me state that I always believe that someone should contribute to their plan up to the match limit that their company offers. If you plan will match the first five percent, then I say at least that amount. Otherwise, you are leaving free money on the table, and that is not a good plan under any circumstance. But after the match is met there may be better options for you for additional savings. Now, let’s look at some of the problems with 401(k) plans in general.
In 1981 the 401(k) was introduced to the American workforce as a means to save for their retirement. Now back then this idea was a complete experiment, and no one was sure if it was a plan that would even work. But as people began saving some 30 years ago in these plans and employers were matching contributions the traditional pension began to fade away. Now instead of having a pension payment in retirement most people have Social Security payments and have to withdrawal a portion of their 401(k) plans for their retirement expenses. We are just now really seeing those people who started with the 401(k) plans back then retire now and here are some flaws that have been observed with the traditional 401(k) and areas that should be of concern to everyone who participates in these plans.
The first glaring problem with a 401(k) is you, as the investor, can be wiped out almost overnight if you are not vigilant. What other plans would an ordinary person invest in that can allow you to lose 30-50 percent of your value just prior to retirement with little recourse on your behalf. As your investment options are limited, you may be stuck in investments that are not ideal for someone who is entering their retirement years. As a rule, your 401(k) will automatically rise and fall with the stock markets where no one has any control. Many retirement planners will say that the markets have had a historical average of 8-11 percent but in the last 15 years it has been closer to being up just 8.4 percent or an annual return of 0.56 percent after the returns have been adjusted for inflation. That is a far cry from 8-11 percent that most people tout.
A significant drawback to 401(k) plans are all the fees associated with the ownership and management of the overall 401(k) plan. There are administrative fees, management fees, trustee fees, stewardship fees, transaction fees and fees associated with the individual mutual funds owned by the plan. Many mutual funds can charge upwards of two percent for all of these fees right off the top. That is terrible news for you the investor in this situation. If the fund had a seven percent return then after fees it would be around five percent, and that can make a huge different over a 30-year period. A $5,000 contribution every year for 40 years would be $1.1 million at a seven percent return. Now that same investment with a five percent return would only amount to $670,000 or less than 60 percent of the portfolio with a true seven percent return. Not the investment that many plans project if you want to take an honest look at the system.
There are no options for cash flow when you look at the structure of the 401(k). It is easy to put money into the plan but then you are not allowed to touch it for the next 20 to 30 years if not longer. That is unless you can maneuver around all the red tape of the IRS rules that govern 401(k) plans. And with no real cash flow value there may be numerous missed investment opportunities that you will be missing over the years. This leads to a lack of liquidity as well. If you need to access your 401(k), you will face hefty taxes as well as penalties as well. And if you can tap into the plan with a loan then if you separate from your job you have a scant 60 days to repay the loan without penalty. Not an ideal situation if the truth is told.
Then there is the fact very few people are aware of what they are investing in from the beginning. By this I mean there are people who work for green companies whose 401(k) has mutual funds that invest in large oil companies and no one is the wiser. Think about it now. How much do you know about your 401(k)? Chances are you do not know what the plan is about to the degree you should. Just because the company limits or picks your investment options it does not mean you do not have to do your due diligence.
Taxes are another area that many people do not fully realize when they think of their 401(k). While all earnings in the plan grow tax-deferred, there are tax consequences that you need to consider. All 401(k) proceeds are taxed as ordinary income and not as long-term capital gains as in a brokerage account. Also, if you are taking advantages of the tax breaks today the tax rates are at historic lows as compared to past years. This means that it is more likely than not your tax bracket will be higher when it is time for you to retire. I know that is not what you think or have been taught to think, but it is the hard truth. I do not see tax rates going down in the future so be leery of just looking at the tax advantages of today and think ahead towards your retirement. Also, you need to keep estate taxes in mind for 401(k) upon your death as this will simply become a giant pile of cash for your heirs unless you follow the proper beneficiary procedures.
Now here is the point almost no one knows about, the government owns your 401(k) and can change the rules at any time. The plan is held “For Benefit Of” or FBO. This means the government owns the account and can change the rules at any time. This has been seen in other countries since 2000 and briefly considered during the recession of 2008 and 2009 in the US. This is unlikely, but we could be a single recession away from this becoming a grim reality.
Now these are not the only factors you need to consider when you invest in the 401(k) but it is a start. Look into your plan and make sure you understand it in its entirety. If you have any question or need any additional information feel free to contact me.
