“Max out your 401(k)” is one of the most common pieces of popular financial advice. Of course, it’s “for your own good,” we are told. But is it really? Today we expose the very real risks of a 401(k), and what you can do to decrease them.
Investing most or all of your money in a 401(k) is very good for Wall Street’s profits. It’s so good that financial firms spend millions lobbying Congressional lawmakers! As a result, the Department of Labor allows employers to automatically enroll employees into a 401(k) plan.To clarify—unless the employee opts out, a part of each paycheck can handed to Wall Street… without so much as a signature!
While a 401(k) plan can have nice advantages such as an employer match, if provided, there are also risks. And for those who rely on the 401(k) as their main or only investment vehicle, the risks are significant. Let’s examine seven potential risks of a 401(k).
Risk #1: No easy access to cash when you need it!
Too many people jump to investing in a 401(k) before they have established a financial foundation through saving. They lock up money until age 59-1/2 and don’t have a proper emergency fund when needed. Then if a job layoff or a leaky roof happens, they raid their 401(k)s.
Unfortunately, a 401(k) makes a terrible emergency fund. Let’s say you need money during a market decline. (Typically high unemployment and economic turmoil happens when the market is falling.) Your $10,000 account is now only $8,000. You withdraw the $8,000 from your account, paying taxes and a 10% penalty. If you are in a 24% tax bracket, you will receive only $5,280.
If the market recovers before you can replenish your retirement account—you’ll lose out on the recovery. Then you’ll have to pay $10k—after taxes, plus interest—to make yourself whole. You do actually pay interest to yourself in this case, but you’ll have to repay nearly twice what you received! (Right now, the CARES act allows higher loan limits, a waiver of the penalty, and delay of interest, which does improve the scenario.)
It is estimated that up to 20% of plan participants have outstanding loans from their retirement accounts at any given time.That’s frightening considering the astronomical costs of getting access to “your” money. (There are obscure tax code “workarounds,” but they don’t fit most situations.)
We are trained to put our money where we have no control and cannot use it. But having liquidity—money you can access easily and quickly without paying a sizeable penalty for doing so—is critical! A 401(k) loan should be a last-resort option for cash—not the default.
Risk #2: Limited investment options.
The investment choices within 401(k) plans tend to be extremely limited—mostly mutual funds. The options are curated by the brokers who procure the plans. While there may be numerous choices, they tend to represent the same type of investment… all with inherent systemic risk.
Your retirement plan choices are a bit like a pizza parlor menu. You have 20 options, but it’s all pizza, perhaps with some pasta on the side. Likewise, your retirement plan offers equities with a side of bonds. All from the same Wall Street recipe book!
There is significant risk when you keep your investment eggs in one type of basket. Investors who have the majority of their assets in a typical retirement account will lack balance and certainty, suffering the roller-coaster ride of the market.
There are non-correlated investments that do not rise and fall with the stock market. What if you want to invest in real estate, start a business, or become a private lender? These are options for those who can start a self-directed IRA. But there are limitations. For instance, real estate is an excellent investment, but owning it inside of a qualified retirement plan is problematic from both a management and tax standpoint.
Risk #3: Risk of significant loss.
A report on CBS’s 60 Minutes TV show inquired, “What kind of retirement plan allows millions of people to lose 30-50 percent of their life savings just as they near retirement?” A 401(k) plan—that’s what kind of plan!
In 2008 and 2009, many people had to delay retirement due to large portfolio losses. The dark humor saying of the day was, “401(k)s are now 201(k)s!”
In 2020, we have heard of investors losing six figures, even multiple six figures in the stock market. Many Americans are wondering how long it will take their portfolio to recover from the “Corona Crash”—and if another has begun. The stock market has partly recovered, but we are far from “back to normal.” The economy is devastated, businesses have closed, and unemployment is sky high.
For those in the FIRE movement—which stands for Financial Independence, Retire Early, the pandemic may prove to be a fire extinguisher. Sam Dogen of Financial Samurai blog predicts the economic impact will send many early retirees back to work. Additionally, “many people who have not yet reached FIRE will probably have to extend their working careers by three to five years to make up for their equity losses.”
Risk #4: Giving up control to the government.
Uncle Sam makes the rules—and can change them, too! The government and the retirement plan administrator determine:
what you can invest in.
how much you can invest.
when you can withdraw it
and what taxes and fees you’ll pay for withdrawing earlier.
Of course, the government can and does change the rules! Recently, Congress passed the SECURE Act which changed the rules around the “stretch IRA”—a strategy that allowed the beneficiary of an inherited IRA to minimize taxes by taking distributions over a lifetime.
The government is looking for ways to collect the tax revenue from retirement accounts sooner rather than later. Could your account itself ever be at risk? We hope not, but we can’t rule it out completely. As my friend Garret Gunderson explains, “your 401(k) does not even technically belong to you. Read the fine print and you will find ‘FBO’ (For Benefit Of). The tax code makes it technically owned by the government but provided for your benefit.”
In other countries, private retirement plans have been raided to fund government shortages. This happened in Argentina in 2008, Hungary in 2010 and Ireland in 2011. Pensions have been raided for a similar purpose in Poland and France. So I would personally not want all of my investments under government watch and rules!
Risk #5: The opportunity cost of limited cash flow.
Every financial choice precludes another choice. While you are dutifully contributing to your 401(k), what AREN’T you doing with your money?
You might feel you don’t have the cash flow to save for a down payment or purchase a home, which strongly correlates with a much higher net worth.
You may avoid investing in yourself through continuing education and mentor ship. You might neglect to invest outside of your 401(k) and end up with your dollars “trapped.” Or you could end up with higher credit card balances, paying extra interest.
Prosperity Economics takes a big picture view of your money, because one decision affects another. Ultimately, you only have one wallet!
Risk #6: Endless fees shrink your account.
401(k)s and the mutual funds that tend to fill them are famous for high fees and hidden costs. David Blanchett, head of retirement research for Morningstar’s Investment Management group, told CNBC that fees for plans at smaller employers can total 1.42%–each and every year. Another study reported in SmartAsset found that 401(k) participants pay an average all-in fee of 2.22% of their assets.
Those fees add up in a shocking way. A comprehensive 2015 study found that in 16% of 3,500 plans analyzed, fees were so high that they “consume the tax benefits of investing in a 401(k) for a young employee.” Research from the Center for American Progress found that the typical American worker earning a median salary starting at age 25 will pay about $138,336 in 401(k) fees over their lifetime.
The cost is even greater for high-income earners and consistent investors. If you contribute $5,000 per year, from age 25 to 65 years old, and your account earns 7 percent each year, your money would grow to about $1,143,000. But if with a two percent fee each year, you won’t have 2 percent less—you’ll end up with about $669,400—a loss of more than 41 percent, or $473,600!
How is that possible!? As Jack Bogle, the founder of Vanguard explained, “What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compound costs.” If you are paying average fees, you are taking all the risk to earn the brokerage almost as much money as you!
Even you want exposure to the stock market, you could be better off setting up your own no-fee brokerage account or IRA and choosing your own no-fee or low-fee investments rather than participating in your company’s 401(k) plan. Especially if your employer does not offer a match, explore other options for investments.
Risk #7: Endless taxes can trap you into staying!
When someone begins a 401(k), an exit strategy is usually the last thing on their mind! But as your account grows over time, it becomes harder to free your money from the 401(k) trap—even with its faults. That’s because you would pay a steep toll in taxes if you ever cashed out your account. (You might also pay a penalty if younger than 59-1/2.)
Faced with the prospect of a sizable, even six-figure tax bill, most people opt to keep their money in their 401(k) or IRA. Unfortunately, that means (unless it is a Roth account) you’ll be paying income taxes on every withdrawal. This is something not everyone fully understands during the decades of funding the account!
Now, you have probably heard that you’ll “pay less in taxes when you’re retired.” But that’s not necessarily true! If you have done a good job of saving and investing, and wish to travel and do fun things, you might even spend MORE than you did when you were younger! It will all depend on what tax bracket you’re in and what the tax rates are.
There is also the issue of the national debt—something that has ballooned to unbelievable levels in 2020. Plus we may be moving towards universal health care or other programs that would expand taxes. Do you really think that taxes are going DOWN?
Unfortunately, as long as your dollars stay in the qualified retirement plan environment, you’ll have the government rules and restrictions. You won’t be able to invest your money in anything you wish, and you’ll keep paying taxes—and possibly fees!
—By Kim Butler and Kate Phillips
In my experience from years of working in the financial services industry is that there are better options than putting all of your trust in 401(k) funds. I prefer 401(k) contributions up to the match level, then you can save and invest elsewhere for greater variety and flexibility.