I go over why you shouldn't use 401k's as a retirement tool and how you can do much better.
I’m sure you’ve heard your friends and family telling you “invest in your company’s 401K”, “it’s a great retirement tool and you get free money”, or “what’s better than free money”. But I’m here to tell you that most of that is complete and utter horse poop.
Here why I think 401k’s are to be avoided at all costs.
1. You are locked in for 30+ years!
Yes, you read that right. Now you might be saying “bro! this is a retirement tool and you want to be locked into saving money”. But my contention with this is, why should we be locked in! Most people don’t know the terms behind this commitment period because they are too lazy to look into it, but before I get carried away, let me dive a bit deeper now and tell you why this is a bad idea. Let’s start with when you get a job. Most people tend to get their start in their mid to late 20’s, so that puts us roughly at 25. This means the next time you’ll ideally want to access these funds would be for your retirement, which according to the 401k rules means you will need to be 59.5 years old. For this example, let’s round up and put that figure at 60. So 60-25 puts you at 35 years. Why on earth would you even think about locking money away for 35 years with almost no control of it. Yes, you can take the money out in some emergencies and I'll talk about that later but still, it just seems like a bad idea to let your hard-earned money be locked away somewhere, in an account where one barely knows the rules, and the growth is minimal at best. That just sounds like a mediocre product and we haven’t even got into the meat and potatoes.
2. There are fees and costs associated with this account
What 401k managers and your employer fails to tell you is that there are massive fees and costs associated in your 401k account that are being passed down to you and there is nothing you can do it about it. An average 401k owner pays nearly 2% of their entire portfolio value towards costs and fees and this eats away at your returns. This is also the low end, that number can sometimes be up to 5%! Yikes! Now it’s up to your employer to negotiate these rates with the 401k administrators but they don’t bother, they just pass that cost down to you and because we don’t read things before we agree to them, we end up paying for it. Some of these stupid fees include items like investment fees (which is a management fee), admin fees (which are the largest portion of the fees that cover the work the people do behind the scenes to manage accounts) and service fees (which are fees you pay when you want to take out loans, swap to another type of account, etc). According to a recent study, a person who starts their 401k at 25 years old can expect to pay nearly $140,000 in fees throughout their lifetime. Again wtf!
“Now if you want to take out some money to use for another reason besides a hardship, say you need to pay for a wedding, you need to loan that money to yourself! Crazy!”
3. You can get your cash earlier, but it will suck both ways
Remember I was talking about emergency pay outs, here’s where I elaborate on that a bit. The 401k labels this emergency pay out as a “hardship withdrawal,” and it is only to be used to meet an “immediate and heavy financial need” which according to the IRS can be covering death related costs, medical bills, mortgage default (aka a foreclosure), loss on a principal property (like fire damage to your home), 12 months’ worth of tuition assistance and lastly it can also be used as “home buying expenses” for your principal home. Here’s the deal with that. Your employer can choose whether to allow this or not and there are multiple stipulations built into it, the worst of it being that you will liable to pay those gosh darned fees on the amount you withdraw, a 10% penalty if you withdraw before 59.5, and Uncle Sam will extend his hand out too. Now if you want to take out some money to use for another reason besides a hardship, say you need to pay for a wedding, you need to loan that money to yourself! Crazy! You have to make fixed payment plans back to your 401k plan with added interest, which if you default on puts you back in the running for paying all the penalties and fees you would if you took a hardship withdrawal!
4. Your employer has a built in 6-year vesting period with you
Here’s the part where we talk about this “free money” aspect. Most people have a 401k where their employer matches their contribution, meaning they will put in a certain amount of cash based on how much you contribute and sometimes that contribution your employer makes can be 100% on a maximum contribution of your income annually. While common, it’s not always the case. And again, I know this sounds like free money, but your employer will only contribute as long as you are an employee but you won’t be able to consider their contribution unless you have worked there for a minimum of 6 years, which is the average for most employers. The issue is the average employee only sticks around for a period of 3.5 to 4.5 years, so all the money your employer has been contributing over those 3.5 years, they will take that all back when you leave the company, leaving you with only your contribution. Also remember there is a limit to how much of your money you can contribute to the 401k amount and this amount is always changing on a year to year basis. You can’t put whatever you want and expect your employer to match that. Messed up right.
5. You can owe a lot on taxes
That’s right the taxes will getcha. Uncle Sam is taking from us left and right. Since you contribute to your 401k with pre-tax dollars, it means when it comes to taking the money out you can sometimes pay a lot in taxes which I think is nonsense. Look at it this way. When you are younger, you actually have a lot of tax write offs that you can claim to offset how much you owe, but as you get older there are less write offs to claim meaning you are kind of forced to pay a higher tax rate when that time comes. Also, who is to say what the state of the economy, the tax rates and the rules will be like when you are 60 years old. Now if you’re the type that says “well I just won’t take out any money. No money out means no taxes, right?”. No. According to the rules you will be forced to start taking deductions from your 401k when you are around the age of 70 so there’s no getting around the taxes that are ready to hit you. The only people that benefit from the tax deductions on 401ks when they are older are the super wealthy. So if you’re not super rich by the time you retire, the taxes will hurt more. I personally am not okay with all that uncertainty in this type of locked program.
So what do we do now?
Now, the question becomes what we can do, now that we know that 401k’s are wack. And the answer to that varies depending on your situation but here is the ideal route.
If you have a job with an employer that offers a 401k and you predict you will stay with that company for 6 years and you can expect your employer to match your contribution, I would start up the 401k and then after 6 years of steady contributions move the 401k over to an IRA account. An IRA account gives you more control over your cash and opens more investment selection. There’re also better options on how to manage the taxes benefits, assuming which IRA account you choose. There are 2 you can choose from. A ROTH IRA won’t charge you tax when you start removing cash for retirement, aka tax free deductions after 60, but you contribute with after tax money (aka the preferred choice for most retirement savers) and a normal IRA give you tax breaks on every year you continue to contribute to it, meaning you contribute pre-tax, but you will pay taxes upon taking the money out when you retire. Hence tax savings now versus the future. Point is, an IRA account is the way to go.
If you find yourself in a scenario, which almost 2/3 of Americas are in, where you have no 401k option from your employer or if you are self-employed, then jumping straight to an IRA is the best option hands down. This is very easily done through a bank and saves you the hassle of even dealing with a 401k to begin with.