In 1978 Congress passed the Revenue Act of 1978, which had a provision that allowed employees to avoid being taxed on a portion of income that they decided to receive as deferred compensation, rather than direct pay. Ted Benna, a crafty retirement benefits consultant, used this provision to create a new and innovative retirement plan for a client. The plan he created is now regarded as the first 401(k) plan.
Over the past 30 years since its creation the retirement space has altered employee retirement and compensation:
- Increase in economic inequality: The Economic Policy Institute released a study proving that do-it-yourself retirement is driving economic inequality, leaving regular Americans further behind than ever. The data shows disparities by income, race, ethnicity, education, and marital status.
- Decrease in wages: The Center for Retirement Research did a study which showed that for every dollar an employer (on average) contributes to a 401(k) match, they pay 99 cents less in salary.
- Decrease in retirement readiness: The Center for Retirement Research also found that there is an estimated $6.6 trillion deficit in what Americans currently have saved compared to what they will actually need in retirement.
The Uncontrolled Variables of the 401(k):
At a young age my pops warned me about following the crowd. He would say, “Always think for yourself because the crowd may not lead you in the right direction.” So following his teaching as a 22-year-old recent college graduate with less than a month of work experience, I decided not to participate in my company’s 401(k) plan. Many factors led to this decision but they all revolve around the concept of control. John D. Rockefeller said, “The secret to success is to own nothing, but control everything.” A mentor of mine repeated this quote during a team meeting. Having heard it before at a Real Estate Investor training, I was excited to finally ask about the meaning behind the famous quote. He then rephrased it and explained that the key to building wealth is control. With that in mind. Let’s explore how a typical 401(k) account gives you little to no control.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” - Warren Buffet
- Control The Market? - As individuals we have no control over the financial market. We can’t predict when the next financial crisis is coming but we know it’s inevitable. In the past 40 years we have had five recessions/banking crises, which is about one every eight year. During the Great Recession (see definition below) some people lost 40% of the 401(k) savings they spent their entire career building. Yes, the stock market is an opportunity to make money but remember losing money could be the difference between retiring at 60 and 65.
"It's my money and I need it now! “ –JG Wentworth
- Control The Money/Retirement age? - You can’t take money from your 401(k) money before age 59 ½ without paying a 10% penalty. There are a few case that allow you to borrow money from your account, e.g. college tuition, but you have to pay interest, fees, and taxes so it is highly discouraged and viewed as a last resort.
"What we learn from history is that people don't learn from history.” - Warren Buffet
- Control Future Tax Rate? - The main argument for funding a 401(k) is that at retirement you will be in a lower tax bracket. However, in 1981 when the first 401(k) plan was created the lowest marginal tax rate (tax bracket) was 0%. During the 35 years since its existence, the lowest marginal tax rate has gotten as high as a 15%. This means someone who could have paid no taxes would now pay 15% income tax. So how certain can you be that when it’s your time to retire, the tax rates will work in your favor? Currently, tax rates change slightly on an annual basis and are prone to vast changes between presidential administrations. Don’t allow the quality of your retirement to depend on the IRS or who is in the Oval Office.
“The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.” -John Bogle
- Do you control your fees? - Do you know the fees you are paying? Did you even know that you were paying fees? A recent study found that 80% of people don’t know the cost of their 401(k) plan and 70% of those people didn’t even know there was a cost for having a 401(k) plan. Yes, 401k plans are allowed to grow tax-free but not without a FEE. Knowing this information, I read through my own 401(k) plan in search for the disclosure of fees, but as anticipated it was not mentioned. The most troubling aspect about 401(k) fees is that they are not based on how well or poorly your account performs you still pay fees. For example, during the recession when people were losing almost half of their retirement money, mutual funds were still collecting fees.
"Can’t take this, Can’t take this, not another day, not another day!” – Parrot Washington Post Commercial
- Control your Career? - How long do you have to stay at a company to keep 100% of their 401k match? 63 percent of companies require about 5 years to be fully vested. For example, if after 2 years at a company they contributed $2,000 to your 401k and you decide to leave, you are only given a portion of the $2,000. This is really important for millennials because we tend to switch jobs more frequently.
Although, I have decided not to participate in my company's 401k plan that does not mean I am against saving for retirement. I am actually a huge advocate. I just believe there are better alternatives which I will discuss in future articles. Nonetheless, be skeptical. Don’t enroll in a 401k without thinking critically about the plan. There are many paths to financial success. Just remember the key is control.
- Great Recession – The recession that took place from 2007 - 2009
- 59 ½ - The age you can access your 401(k)
- 10% penalty – If you take take your 401(k) fund out before age 59 ½, you have to pay a 10% tax in addition to paying income tax. For example - if you take out $100 you will be taxed $10 first. Then the remaining $90 will be subject to income tax.
- Mutual fund - Investment vehicle (company) made up of a pool of funds collected from many investors (401k contributors) for the purpose of investing in securities such as stocks and bonds.
- Portfolio of stocks – Group of stocks