The 401 (K)

I sit with families everyday advising them on how to plan for retirement. Usually, when formulating a plan I will eventually hear “well I put most of my money into my 401(K).” To which I always ask “why?” A question which usually does not get answered by more than a shrug.

In my humble opinion the 401(k) is the best farce ever cooked up by the government. Here’s how it works, in the U.S tax code section 401, paragraph K it allows for people to set aside a portion of their  pre-tax income into an investment vehicle known a s mutual fund. So, say someone makes $100,000 a year and they decide to put away 10% of their income into their 401(k). They are now only taxed on $90,000 of their income and that $10,000 is now growing tax deferred in a mutual fund linked to the S&P 500. This sounds great, they save some money on taxes, and enjoy growth they aren’t taxed on, yet.

It gets better, not only do they get to set aside pre-tax money but their employer can match their contributions. So, if this person sets aside $10,000 and their employer matches that money every year their investment has enjoyed 100% growth before you even take into account the market growth. Oh boy lets all do this right??

WRONG! Now even though employers can match 401(K) contributions, they are not required to, and those that do usually only match up to 5% of your income. So if you decide to contribute 10% your only getting market returns on your other 5%.

Now, market exposure means that there are no guarantees on your money, so there is the potential for loss. Many families had entire fortunes and savings wrapped up in 401(k)s and lost 40-60% during the economy collapse in 2008. So if you had $100,000 and lost half of it, the market would have to double just so you could break even and get back to your $100,000.

But, we’ll remain hopeful and say the money is constantly increasing and you’ve got a nice chunk of change built up. Oh no! Your transmission goes out on your truck and you need money quick to pay for it. Just take it out of the 401(K) right? Sure, if you would like to pay tax penalties for accessing your funds before the age of 59.5. Yes, that’s right you are taxed 50 cents on the dollar for pulling your own money out of your account. So to get the $5,000 you need you will have to pull $10,000 out of your 401(K).

Okay, so you’ve worked hard, you’ve saved, and never touched your 401(k) money. It’s grown tax deferred for 35 years, you saved all kinds of money on income tax, your 65 and you want to start pulling money out to live on. Look forward to more taxes anyways, when you pull money out of your 401(K) even after the age 59.5 you are then income taxed on all of your withdrawels. In short, all the money you saved on income taxes over the last 35 years you will pay back in full in 2 years, and then again every 2 years after that.

In short I once again say it is the best farce ever cooked up by the government, so research before you invest.