Why Invest in a 401(k)?

When I do a financial plan for a new client, part of what I analyze is investment structure. Typically, I see the grand majority of an individuals or families wealth in tax deferred accounts, such as 401(k)’s, 403(b)’s, or similar programs. This is very common because most companies will give an incentive to save into a retirement plan by matching your contribution to a certain level. Also, having money taken straight out of your paycheck and deposited into a retirement account is a great way to save automatically for your future. The most common type of retirement plan I work with is a 401(k), so I’m going to focus on that.

The big advantage of contributing to a retirement plan, besides saving for retirement, is reducing your tax bill today. Whatever you contribute to a 401(k) is money that you don’t need to pay taxes on. That benefit can be quite large, especially in states with high taxes. For example, here is an example of taxes due for a client living in CA:

  • 6.2% Social Security tax on the first $118,500 of income
  • 1.45% Medicare Tax
  • 8.2% CA State Income Tax + SDI
  • Plus the regular federal income tax

Looking at the above, if your federal effective tax rate was around 20%, then for every $1,000 you contribute to your 401(k), you save $358.50 ($1,000 * (6.2%+1.45%+8.2%+20%)). When you think about it that way, then the net cost of saving a $1,000 is only $641.50 due to the tax benefit ($1,000 – $358.50). This makes tax deferral very appealing because you get an immediate benefit today! On top of that, most employers will match what you put into a 401(k) plan. As an example, if your employer matches 100% of the first 3%, then the first 3% of your contribution earns a 100% instant rate of return! So I advise at the very minimum to take full advantage of your employer match.

However, I see three major disadvantages of putting the majority of your money into a 401(k) or any tax deferred plan for that matter. The first is that the money is not easily accessible. All of these plans are meant for retirement, so they aren’t meant to be used for anything but retirement. IRA’s have some limited withdrawal options you can read about on the IRS website here. 401(k)’s will sometimes allow the investor to take a loan against the 401(k) up to $50,000 or half the account value, whichever is LESS. I have seen a couple clients get into trouble with a loan because if you are laid off or quit, the loan becomes payable typically within 90 days. If you don’t pay it back, it is treated as an early distribution subject to taxes and a 10% early withdrawal penalty (if under the age of 59 1/2). Therefore, I always advise clients to create and maintain a liquid investment account that they add to on a regular basis. This could be as simple as a joint mutual fund account. That way, you have something liquid and accessible within a week for things like a new car, home repairs, or maybe an investment opportunity. I typically set a goal value of the liquid account to be $50,000 – $100,000.

The second problem is that 401(k) plan may have limited options. When your company offers a 401(k) plan, it costs them more money to have more investment options. That is why I typically see a 401(k) plan offer many US Large company investments, one or two mid and small company funds, one or two international funds, and then income funds. This limits choice and flexibility when it comes to investments that you can pick. Also, there have been several lawsuits brought against companies in regards to having investments that are too expensive and/or not in the investors best interest. Such as a lawsuit brought against Ameriprise Financial where the employees sued the firm and won a $27.5 million dollar settlement back in 2015. One of the newer features of 401(k) plans from large corporations is the ability to do a ‘self-directed brokerage’ account. Where you transfer your 401(k) money into a 401(k) investment account where you do the trading and select investments. But then you have to research, pick, and monitor the investments. As another option, my office has the ability to manage money in those types of accounts if the money is held at Fidelity, so we can provide trading and management.

The third problem is when you are forced to start taking money out of your 401(k) plan at age 70 1/2. Since all the money in your 401(k) plan is deferring taxes, the IRS and the government don’t want to let you defer forever. They want their tax money! So at age 70 1/2, they force you to take money out through what are called Required Minimum Distributions (RMD). In the year you turn 70 1/2, you have to reference an IRS life expectancy table depending upon if you are married or single, and what is the age difference between you and your spouse. The table will show you a number such as “27”. So you have to take the balance of your 401(k) on December 31st of the previous year and divide it by 27 and that is your RMD for the year. As you get older each year, the number gets smaller and you are forced to take out a higher and higher percentage. If you have a large amount of wealth in your 401(k) plan, this can lead to taking out very large sums of money that force you into higher tax brackets. To avoid this, it is wise to do projections and balance out your investments between tax deferred accounts, taxable accounts, and tax free accounts. An example of a tax free account would be a Roth 401(k) or a Roth IRA. It is also important to make sure you have your beneficiaries properly named on these accounts, so the beneficiaries are not forced to take out all the money at once and trigger taxes on a large lump sum of money. I advise talking with your advisor to schedule a ‘beneficiary review’ on all your accounts and estate planning documents.

In summary, I do suggest people take advantage of contributing to their work retirement plans. However, it is important to have balance in between liquid and tax deferred accounts, and balance between tax deferred, taxable, and tax free investments. Feel free to call or email me with comments, questions, or suggestions for future blogs!