401(k) as a good investment plan? Think again.
Your employer offers it as the 'go to' retirement tool. You may even know boomer or two that are living off it. Financial Advisors everywhere are big proponents of 401(k) plans. And really, the benefits of a 401(k) are substantial. They include deferment of taxes, employer matching contributions, diversification, and yearly contribution amounts.
However, with employer contributions dwindling from dollar for dollar to cents per dollar, and with new limits on the amount you can contribute every year well, a reality check on tax brackets, that puts a chain on how far your 401(k) can run freely.
But for me, what's wrong with your 401(k) is what I learned in my Financial Markets Timing class in business school. In order to be successful as an investor, you MUST stack the odds in your favor. That's right, anyone can be an investor. But not everyone can succeed. A successful investment is that which yields a GREATER rate of return (ROR). Planning (to include risk & valuation), strategy, and timing are the keys to a successful investment and are "stacking odds" in your favor. Thousands of people with a 401(k) plan averaging a rate of return between 4%-6%, hardly seems they have "odds" in their favor. Besides, that is not what a 401(k) does. In fact, there are many factors working against you in a 401(k) which limit your odds of success. But read on to learn why the 401(k) may not be a successful investment for you.
1. It becomes an enormous tax liability and not a better standard of living
Think about it this way. Let’s say you are putting $18,000 a year into your 401(k) at age 35. You would then be deferring taxes on $18,000 each year you deposit the money. When you retire, you will have amassed a large sum of money in your 401(k) - well over a million. But that money has never been taxed. Now as you withdraw these savings, you, or your heirs, will have to pay taxes on every penny of it. It's like a farmer being taxed on the crops - not on the seeds. And which you would you rather pay taxes on... your retirement seed, or on your retirement harvest? The fact is, you will owe income tax on ALL your withdrawals - both the money you contributed and the gains on your contributions - and not necessarily in the bracket you think.
Many will say, take a tax deduction today and pay tax later when you are retired and in a lower bracket. Here's the thing. Remember: Money you withdraw from a defined contribution plan is always taxed at your income tax rate at the time you withdraw it. You may be in a lower tax bracket because your adjusted gross income will be significantly less. But, that still means less money. And if you happen to make or collect benefits (combined) of more than $32,000 a year, you will still pay taxes in that bracket. In California, I'd say about a 28% bracket - when you believe you're in a 15% bracket. Have you factored in property tax, sales, etc. That's right, there may be a few complications, such as whether there is more income generated by Social Security, interest, dividends or capital gains. That income that would also include the 401(k) distribution, you may lose out on some deductions or exemption amounts. Did you know that a 401(k) distribution could make up to 85% of Social Security benefits taxable when prior to the distribution they were tax free. That's a lot of taxes for being in the "lower tax bracket".
Albeit, things may work out where you don't make $32,000 per year in retirement, and your home is paid off, and you feel you now have a bit of a positive cash flow. That all looks good on paper. Statistically, unless you've amassed a large sum of wealth, most regular American's standard of living actually decreases after retirement. Harvard & MIT professor, Robert Merton calls it the "coming retirement crisis", where standards of living will fall for retirees, not increase. There is serious concern that retirees will run out of money in their lifetime. Why? Well what do retirees do? Real estate investments, vacations, new cars, health care costs, nursing home or home care, bills, etc etc. But now it's on a fixed income. How long do you think the current standard of living will last on that? Hence it will by default, decrease.
And imagine if you haven't paid off your mortgage by 65, or 70 even 75? A third of homeowners 65 and older had a mortgage in 2014, up from 22% in 2001, according to the Consumer Financial Protection Bureau. So now, you still have a house payment, with less adjusted gross income, a slim cash flow. How much does that lower tax bracket really feel now?
As Kiplinger pointed out, "You might agree that the good folks in Washington, D.C., have a spending problem. But how are they going to pay for it all? You can bet your last dollar that they all know that there are trillions of dollars sitting in 401(k) and 403(b) plans (not to mention Roth & IRAs) that have never been taxed. Do you really want the bulk of your retirement dollars sitting in the cross hairs of a government with a bad spending habit?"
2. What you put in, is not what you get out.
The S&P consistently made over 10-15% on its rate of return (ROR) for the past 20 years - even with the market crash of 2008. Yet, the average 401(k) only makes 4-8% on its ROR. However, unless your company is matching your contributions dollar for dollar, that retirement isn't going to give you the rate of return that other products in may, such annuities or mutual funds, or equities. In fact, you may actually lose alot of your diversified money if the market goes south or worse, if it collapses (as in 2008). Side note; a financial markets collapse is expected now - statistically a financial collapse comes every 8-10 years. That being said, how safe is your money when the next market crashes? Wouldn't it be nice to not be on the losing end of that market crash - even, be in a position in which you can take advantage of such an event?
3. Will you outlive your 401(k) retirement money, or will it outlive you?
According to Fidelity Investments (who happens to control a vast majority of US 401(k) accounts) in 2016, 95% of American's 401(k)s averaged a total $95,000.00. Now, that may seem like a good savings- and by all definitions it is. Americans are contributing more and the stock market is up. But have you ever spoken to your advisor or broker/dealer about running out of money? 46% of US business owners say they fear running out of money in retirement, more than dying prematurely. And by the way, dying prematurely, can wreak havoc on your 401(k) dividends.
The fact is that while most of us live on a household income of $75,000 per year (US Census Bureau average), we have a standard of living that is more likely around $53,000 per year. With this, we pay bills and mortgages, take vacations, pay for college, and save. Does it seem at times you don't make enough income? Have you ever held off on a home repair, business start up or improvements, purchase of a new vehicle, or forgone the ideal vacation cause you couldn't "afford it right now"? Do you think this will change once you retire? Think of this - you can't live without an income right now - yet that's what we all think we can do that for the next (20) years of retirement. Worse yet, how far in your current standard of living will that $95,000 stretch out over 20 years, or 15, or even 10. Would $7,100 per year on top of Social Security be enough for you to live comfortably in retirement? Probably not.
4. The dipping into that retirement egg is bound to happen
Do you plan on getting sick? No one does.
Do you have the money for a down payment on that new house? Maybe not.
Do you need to pay for that college tuition right away? If your child merits it.
Are you going through hardship - a foreclosure or job loss? Many do.
While all these are good reasons to withdraw money from your 401(k), you may want to think of the downsides of taking out money before age 59.
Here are two. To begin, it's a loan, not a withdrawal. And as so, you instantly get penalized 10%. In addition to that 10 percent fee, you'll be subject to paying your ordinary income tax on that amount. Although there are instances where this may be averted, the majority of the time, you will be penalized.
Chances are you'll come back for more. Data shows that 1 in 4 workers in America have taken out a loan form their 401(k), bringing this type of borrowing to a ten-year high. Over 45% of these workers, came back for a second loan.
Fidelity studied the patterns of 180,000 borrowers who were active participants in a 401(k) plan over the last 12 years. Among this group, the majority — two-thirds of employees — took more than one loan over that time period. But 25 percent of borrowers came back for a third or fourth loan, while 20 percent came back to their retirement account five times or more.
Borrowers didn’t typically resume their original savings rate until two years after the loan was paid off. “It’s a double whammy,” says Fidelity. “The money is out of your account and while you are paying it back, you can’t afford to contribute as much.”.
"Using your retirement account to pay for anything other than retirement is an expensive long-term move, so resist the urge to dip into it until you're actually retired. It may seem tough now, but your self-control will pay off in the long run!" says an expert contributor from NerdWallet.
But what's the forecast?
While there is currently a spike in hardship withdrawals, the #1 reason for dipping into a 401(k) is... MEDICAL BILLS. Even more alarming according to USA Today, "63% of Americans haven't enough savings to cover a $500 emergency [room] bill". And yes, it gets worse. Over 60% of the bankruptcies in the U.S. are directly tied to the uncovered medical expenses that follow a critical illness such as heart attack, stroke, and cancer. 80% of those bankrupted patients were covered with health insurance.
As the rates of critical illnesses and the costs for treatment continue to rise, Fidelity says "retirees now need $275,000 just for health expenses". It added, “It’s critical that people include health care as a significant part of their retirement plan”.
According to eHealth, the average cost of healthcare insurance including deductibles is about $9,000 for a family of (3). That same coverage, with inflation, fees, and deductibles is projected to jump to $16,000 by 2024. With a retirement 401(k) average projected to be at $120,000 during that same time, do you think YOUR healthcare needs will only increase or decrease? Will your 401(k) stand to the test of retirement and a good standard of living?
What can you do?
Well, after all you should invest in your future. But you need to: Leverage that money. Shelter those funds from taxes. Protect your self when, not if, that sudden illness happens. More importantly, get on a financial vehicle that offers control, options, flexibility and security while removing stock market risk and tax risk, all with a guarantee and all tax-free.
Impossible? Many Financial Advisors think so. Which is why they recommend a 401(k). But, think of this - by only using a 401(k) you are bypassing numerous others (at least 400) other IRS codes that can offer you the things we just mentioned. Its time to choose a good retirement plan. Roth IRAs and Life Insurance vehicles have better if not the single biggest benefits in the tax code. So, Its time to transfer your taxable retirement to a non-taxable retirement, where you are guaranteed to not lose any money, and which you can receive money during a sudden illness, and leave a legacy to your family and not a burden.
Contact your Financial Advisor to review your options or for more in depth information and solutions, contact the contributor to this blog, Ed Mendevil.
All information included in this article was taken from personal experience and education, colleague articles, financial expert opinions, and data collected by private entities and government agencies. No claims are made to content nor advice and article does not promote one investment vehicle over another, although factual biases are pointed out. About Ed Mendevil - a Retirement and Financial Specialist with Antiqua Financial in partnership with Financial Concepts of America and the Alliance Group is a certified financial markets professional in stocks, forex, and (digital) cryptocurrency. He serves as an investment group analyst, professional day trader, financial educator, and wealth protection specialist. Ed can be reached at (714) 239-1100.
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