Is Your 401(k) A Scam? (Avoid These 401k Traps)
Is your 401(k) a scam?
The 401(k) has become the most popular retirement plan offered by many employers in the United States. According to Fidelity, the number of 401(k) millionaires recently hit an all-time high.
(Fun-ish fact: The 401(k) plan is named after a section of the U.S. Internal Revenue Code.)
401(k) plans often get a lot of criticism due to some of the limiting features the plans offer. While the plans have limited features compared to traditional stock brokerage accounts, 401(k) plans can be great for the average person. Especially those who don’t want to worry about learning how the financial world works.
It also makes sense to invest in a 401(k) plan when your employer is offering a contribution match (which is essentially free money) or if you’re looking for additional tax benefits.
But it might not make sense to invest in a 401(k) plan if your employer does not offer a match or if you do not need the additional tax benefits.
So are 401(k) plans a scam?
No. 401(k) plans are not scams. But they might not be for everybody. There are several Pros and Cons to 401(k) plans, and that’s what we will go over in this blog post.
But let’s first touch on how 401(k) plans work.
How do 401(k) Plans Work?
Employees who sign up for their company 401(k) plan will be able to set a percentage of each of their paycheck to be automatically invested into an investment account.
There are a few different types of 401(k) plans with different benefits. The most common 401(k) plan types are the Traditional 401k, Roth 401k, and the Solo 401k plan.
Traditional 401k (Pre-Tax Contributions + Tax deferred)
Roth 401(k) (After-Tax Contributions + All growth is tax-free)
Solo 401(k) (Self-Employed 401k Plan, Contributions are tax-deductible)
401(k) plans are restricted for retirement, so you will not be able to withdraw from your 401(k) penalty-free until you are 59.5 years old.
There are exceptions to this rule, however. Such as using your 401(k) to pay for unexpected medical expenses, disabilities, or even preventing eviction or foreclosure.
Suppose you do have to make an early withdrawal (before the age of 59.5) from a 401(k), and it is not considered a “Hardship Withdrawal.” In that case, you’ll typically be on the hook for a 10% early withdrawal penalty and any income taxes you may owe on the money you withdrew.
So yes, you can still withdraw from your 401(k) at any time, but you will have to pay a penalty fee if you are not at least 59.5 years old or have a qualified “Hardship Withdrawal.”
What are the benefits of a 401k plan?
1.) Lower your total taxable Income (Traditional and Solo 401k only)
If you contribute to a Traditional 401(k) or a Solo 401(k) plan, the contributions will lower your total taxable income. Your pre-tax contributions are then tax-deferred until you withdraw them in retirement. So a great way to reduce your taxable income and save on taxes!
2.) Incentives long-term holding
The earlier you start investing, the more time your money has to grow. Although 401(k) plans have withdrawal restrictions in place, those restrictions incentivize people to hold their investments for long periods. Compounding interest is a powerful force. But that “compounding force” only works if you hold your investments over long periods.
3.) Tax-free growth (Roth 401k only)
Unlike a Traditional 401(k) or a Solo 401(k) plan, a Roth 401(k) plan allows you to invest after-tax dollars for retirement. Meaning that you will pay income taxes on your contributions, but all of the growth in your Roth 401(k) portfolio will be tax-free. (Just like a Roth IRA).
4.) Employer Contributions
If your employer offers a contribution match, it’s essentially free money.
Let’s say your employer matches up to 6% of your 401(k) contributions.
If you make $60,000 each year and contribute 6% to your 401(k) plan (6% of $60,000 = $3,600), your employer will also contribute $3,600 to your plan.
You contribute 6%: $3,600
Your employer contributes 6%: $3,600 (essentially free money)
Total contributions: $7,200
It’s hard to pass up the benefit of free money, even though 401(k) plans, in general, might have higher fees or limiting features. (more on that below).
What are the drawbacks of a 401k plan?
1.) Higher fees
One of the biggest downsides to 401(k) plans is the high fees. The 401(k) administrator will typically charge an annual fee. It could either be a percentage of everything you have invested or a fixed fee amount.
In addition to the administrative fee, the funds you can invest in will typically have higher fees than average.
The average total 401(k) plan fees range anywhere from 0.37% for the (largest plans) to 1.42% (for the smallest plans), according to a CNBC article.
2.) Limited Investment Options
What you can invest in will typically be limited in 401(k) plans. You will normally only be able to invest in a few funds, not individual stocks, and those funds will usually be limited.
According to FINRA, “Most 401(k) plans provide at least three investment choices in your 401(k) plan, but some plans offer dozens. The average plan offers between 8 and 12 investment options.”
On the bright side, almost all 401(k) plans have some sort of S&P 500/large-cap fund, which is my favorite way to invest.
3.) A wait until you can keep company contributions
Unless your company’s 401(k) plan offers 100% vested contributions right off the bat, you may have a “waiting period” until your employer contributions are entirely yours. When employer contributions to a 401(k) become vested, it means that money is now entirely yours.
If you leave a company before all of your employer contributions are 100% vested, you may lose out on some of the money your employer contributed.
4.) You may be forced to withdraw your money after a certain age
401(k) accounts also have required minimum distributions starting at age 72, which means you will be required to withdraw a certain amount of your investments beginning at 72.
That goes for all traditional 401(k), Roth 401(k), and Solo 401(k) accounts. This could make it tricky tax-wise if you’re pushed into a new tax bracket due to forced withdrawals, social security, and any other assets you might have at retirement.
However, you can avoid the forced withdrawal requirements by rolling a 401(k) into a Roth IRA, which does not have mandatory withdraws.
Do millionaires use 401(k) accounts?
401(k) plans have been a popular way for many Americans to invest for their retirement. A new record number of 401(k) millionaires was hit at the end of 2021. With a total of around 442,000 401(k) accounts having over a $1 million balance.
Further reinforcing the critical role 401(k) plans are playing to help keep people on track for retirement.
My Thoughts: Is 401(k) A Scam?
At the end of the day, I think taking advantage of any 401(k) employer contribution match is a must. It’s essentially free money from your employer and a 100% return on whatever you invest into the plan.
Yes, 401(k) plans will tend to have higher fees, but the employer contributions tend to make up for the higher fees.
If you ever leave your job down the road, you could always roll over your 401(k) to an IRA to save on fees and have more investment options down the road.
Unless you’re looking for additional tax benefits, I would only invest up to your employer’s match and invest the rest of your money in either a traditional IRA or Roth IRA.
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As Always: Buy things that pay you to own them.
-Josh
Blog Post: #020
