401k Good, bad and Ugly

Back again to my real job (which is not complaining about politicians).

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401k Plans are a type of qualified retirement plan. Most of these share similiar features that make them an imperfect way to save for retirement, at least by themselves. We are sold on them for a variety of reasons, that the company matches, that it is easy, that it will grow, and that we receive a tax break for them. Ultimately we are told also that we will be in a lower tax bracket when we receive distributions, which makes the tax deferral a useful strategy. I propose to examine these tall tales and see what's left of use.

First keep in mind there is one true tidbit of note and use. The employer match. This is free money. It's not as substantial as people think. If they gave us a check for us to do with as we pleased immediately, it would be a true match. As it is, the money is subject to a partnership. With the I.R.S. Who tells us how much they are going to take. Doesn't sound like a partner to me. Additionally, they tell us when we can use it. If we want to use it sooner, they usually hit us with amazing penalties and taxes. So ultimately that match turns out to be alot less because of the eroding factors of taxes and time. But yes, it's still free money. That's the good.

Now the bad. It's true it is easy because the money comes directly from our paychecks. But the tricky part is where it goes. Some companies require the match or even the entirety go into company stock. This is really dangerous. Relying on one stock for financial independence is generally ill-advised to begin with. But when that stock also happens to be your employer, if they go belly-up not only would you lose your retirement, but also your job. The double-whammy is certain failure. My advice there is to look for a way to move it as soon as possible. Even without a forced match, many people are overwhelmed by the options, large-cap, small-cap, etc. Without someone of reasonable economic education to advise them, most people either choose to invest when they should be saving (which is riskier) or save when they should invest (which is often too conservative). Concurrently, many people treat this as a private savings account that they can use. When they switch employers, rather than rolling over the accounts, they spend them. Thus not only is the money used poorly, it's gone and it generates a huge out of pocket tax burden. This is really, really bad.

The ugly is the last mystery and myth behind the curtain. We are told that we are receiving a tax break and that we will be in a lower tax bracket when we go to use the money. First of all a tax deferral is not a tax break. The tax is still there, but now it is an uncertain tax that we will owe on the earnings as well as the principal. No problem, we're told we'll be in a lower tax bracket when we retire. But how does one achieve this mythical status? There are three ways to be in a lower tax bracket. First is deductions, such as home mortgage interest, but the house is paid off usually by that time, so that's out. Second is children, but the kids better be moved out by 59 1/2. So that leaves make less income. Since many people may be foolishly counting on pensions (which are dying off) or social security income (already dead to me), this is entirely possible that it will be true that there will be less income. But is this assumption that we will have less income a good one, or even a healthy one? I submit that it is not. Consider the expansion of technology that has occurred over the past 30 years. Did the average person have a computer, cell phone, DVD player in their homes 30 years ago? They did not. These are all new expenses to a daily lifestyle which is potentially increasing. Did the average person spend as much on medical care? They did not. The assertion that we will need less money to live on when we retire is probably a poor diagnosis. And in fact, we find evidence that it is a poor diagnosis when we examine what financial planners are telling us. They tell us cure to this problem is to work longer or accept lower standards of living. This is a cure? Why not just simply keep the same standard of income to begin with without having to work longer? Shouldn't this be what our planner has been doing for us?

There is still another problem. The tax is still out there floating on us. We cannot say with any certainty what the tax rates themselves will be in the future, but it is perhaps safe to assume they will be higher than they are at present. If that's the case, even if we stay in the same bracket we will pay more. It's entirely possible we could move into that lower bracket and still pay more. Taking the lack of control we have over tax rates out of the equation, the assumption that we should be in a lower tax bracket is still valid. But we can only do that by having income that is not taxable. The income from a qualified plan, the 401k, is entirely taxable. Both income and principal are sitting there over many years generating interest and earnings for us, and our partner. Einstein called compound interest the 8th wonder of the world. This would be true if it wasn't subject to compound tax as well. Our partner, the I.R.S, will decide to tell us when we go to retire and spend this money what they will take of it. Sharing in our success and tireless saving with the greatest of ease.

So what can be done about it? Certainly getting the free money from our employers is a laudable goal. Beyond that, there is no reason to use a 401k as a vital asset for our financial independence. It must be combined with other more flexible (and non-taxable) methods in order to work effectively. There are some better options coming into the situation in the form of ROTH 401ks for example. But thus far, few employers have gone into this, and even fewer will have bothered to explain the potentially vital difference. ROTH accounts are taxed on the initial contribution only, all the earnings are free of tax so long as they are used in specific ways (such as retirement, but also education, buying first home,etc). This subtle difference is potentially a great one when we go to spend the money we've earned over a lifetime.