Today I'm going to take a devil's advocate view on 401K plans. The bottom line with a 401K, just like any investment strategy, it's not a one size fits all. It's not a set it and forget it, solve all my problems thing. That's the “scam” I want to discuss today, which is something people don't talk about all the time, the disadvantages of 401k investing. Let's jump right in.
The first thing to consider when looking over your company's 401K option, is that not all 401K plans are equal. What somebody's getting at one company might be totally different than what you're getting at yours, and so that's where you have to make a choice of how much you want to invest in it. Right off the bat you've probably heard that some companies match a certain portion of your deposits in 401K. This can be a great way to get so called free money, but not every company does it. If your company does not offer a match then you have to ask yourself, “Is this the savings vehicle that I'm interested in?” If matching is not available for you, then it could change your perception of saving in a 401K.
This post originally appeared as a video on the 40 Finance YouTube Channel
The second thing to investigate is the vesting schedule. This gets overlooked a lot too. In some cases you could have to work at the company for three, to five, to seven years to fully own the money that they put into it. If you're at a company that has a vesting schedule of three years and you find a new job after one, then the money that they contributed to your account is no longer yours. That's part of the “golden handcuffs” that keep people in the same employer. If you're young and you anticipate you'll be switching jobs, or you're going to climb the career ladder as quickly as possible, then the matching contribution may never even land in your bank account. That is something to consider when you sign on with a new employer.
Next up, we have to look at what are the investment options for your 401K plan. I've seen quite a few, particularly in small businesses, that only give you 10 or 12 different options for mutual funds. While those could be suitable for a long term investment strategy, they likely don't work in the short term. If you're picking investment products that don't really match your goals, or are not in the markets you think will grow in the future, then you're actually being forced to invest in strategies you really don't believe in. Make sure you understand what your investment options are with your 401k plan.
Don't forget to look at the fee structure of the offerings in 401k. Fees come into play with every financial instrument. 401K's fees are not much different from paying commission on stock purchases and built-in ETF fees. However, you do have to be careful because if your 401K pushes you towards mutual funds, then that's the kind of thing where you could be paying two or three percent per year, as opposed to an ETF that only charges .53% per year. The worst case is that you would pay fees in your 401K that outweigh the benefits of its' tax free status. That takes your financial advantage out of the equation and you would be better off investing as a retail investor.
The other big disadvantage with 401K's in my opinion, is the withdraw rules. These are designed to force you into saving for retirement. But everyone has different plans. If you are raising a family of five like me, then retirement isn't actually the first thing on my mind. Just be careful and make sure that we have access to our money when we need it.
The current withdraw rules for a 401K to avoid the most tax and penalties, is 59 1/2 years old. I'm 40-ish years old with three kids. That's 19 and a half years away. That's great for my retirement, but if something comes up before then I would like to have access to my money…at least the original deposits that I put in.
If you do take your 401k savings out early you will incur a penalty charge. You pay the taxes that you “avoided” when you were making deposits PLUS plus another 10% penalty. That's a tough nut to swallow if something very small comes up and you're forced to make a withdraw. You're basically paying more in fees than the original money you saved.
Now, there are exceptions. If you have a healthcare need, or certain other financial hardships, you can withdraw without the penalty. However, if your transmission fell out of your car, or some other thousand dollar expense, your withdraw is actually going to cost you more than it would have cost you in your paycheck. And for that reason I don't think the 401K is family friendly in that sense. Yes, there are some other avenues to save for education, but at the end of the day it gets back to liquidity for me. I want to be able to access the money that I put in there, without paying additional taxes and penalty fees if needed.
Ultimately I don't believe anyone should have their entire nest egg in a 401k. It would be severely limiting from a family perspective. It makes sense to contribute to a 401k up to the company match, but make sure you have a solid savings of cash, or a retail brokerage where you can access that money as you need it.
Opportunity cost is another consideration. Again, it's great to save up $300,000 in your 401k by the time you're 49 years old. However, you can't get to it without massive penalties until you're 59 1/2 years old. What if you have interest in starting a business? Or investing in real estate? Don't count on your 401K to fund those, because you'll actually lose with all the penalties that are coming in. If you have the ambitions of starting a business then know that your 401K money is off limits for those things. Don't build your whole future in a 401k because it's just too hard to get money out.
What about transferring retirement accounts? If you do transition careers and companies, you can do a free transfer say, from your company's 401K to a Fidelity 401K. Transferring money from one place to the other is free. What everybody forgets though is, reinvesting in new securities in the new 401k involves fees. If you were paying fees for mutual funds in 401K A, and then you move it to 401k B the TRANSFER is 100% free. However, reinvesting the transferred money into new investment options is going to cost you money. There are fees involved with security purchase. So while there is no free transfer 401k money, there is financial incentive for all these companies to move you from one nest egg of money to the other.
Next up, DCA, Dollar Cost Averaging. That's not always the best way to invest. Look, time after time the market goes up and down, we all know that. Dollar cost averaging is not a horrible strategy over long periods of time, but when you think about things like the recent spikes and bubbles that we've had in the stock market, those are actually times to not invest in the stock market. You're trying to get in low, and sell high, right? If your paycheck is always being forwarded onto a certain mutual fund or strategy, you have a limited option on how you're going to invest. Me personally who follows the stock market everyday, there might be certain bubbles where I'm like, “Hey, pause. I'm not buying anymore of that investment option. Instead, I'm going to stockpile cash. Then, when the market dips I'm going to take my stockpile of cash, and go buy more at that point, when it's the lowest.” Really hard to do if you're in an autopilot retirement account.
Another thing that changes right under people's nose, is company's stock fluctuations. If you work for a big corporation, they don't force you to buy the company's stock, but that option is right there front and center. If you work at, I'm just going to pick on Fidelity today. If you work at Fidelity and you have option to buy Fidelity stock and you're not careful and you buy all Fidelity stock, 'cause you're like, “Hey, I'm on the Project Management team, and this project's awesome. We're going to make a million dollars.” That's great, but everyone knows that Fidelity, like every other company in America, is going to go through a rollercoaster ride. Where they're at 20 years from now, there is no promises, right?
Think about Enron and some of these other scandals that we've had in the past, people lost everything. Their 401K, they put it all in Enron, everything was great, money was being made. Until we found out that the accounting practices were subpar, then the stock crashed. That means 401K's crashed for those people, and they're out. It's a gamble to invest in any company, any one company on any investing platform. The problem on 401K's in certain companies, is that options front and center, and people who don't think about it too much will put way too much money into those single companies. Just be aware.
Another popular “fact” to read more on is the concept of tax brackets in retirement. Everyone makes the assumption that, at 25 years old you're in a certain tax bracket. Then, when you retire you'll be in a lower tax bracket. In theory you get taxed higher supposedly at 25 then you will be at 60 years old. However, those are the tax brackets of today, and we have no idea which way that's going to go. To bank on that strategy alone, it COULD be a reason to invest in 401K's today, right? It COULD also be a disadvantage if things don't go exactly the way we hope they will. That's something to keep in mind. If you're planning for taxes and you're investing because you save on taxes on the way in, and taxes on the way out. I would consider that concept to be very unstable, and while you might come out ahead in today's terms, it is not guaranteed.
401K's are not an evil scam. There's a place for them in your investing strategy, but I definitely would not throw your entire life's ambitions into a 401K though. Again, this is just my opinion. You can read plenty of articles that claim “401K's are the greatest thing of all time.” If that's your take, then by all means, have at it. I could easily be wrong. Nonetheless, I hope you enjoyed this contrarian view.