Is Your 401k Plan the Equivalent of a Television with Only Four Channels and No Remote?
Most Baby Boomers remember sitting around a small black and white television with only four channels and no remote when they were kids. Gen X remembers when MTV and VH1 hit the television and could bounce back and forth with ease with the remote. Millennials added the internet and Wi-Fi to their repertoire. The waya we received our information and entertainment is not the only thing that has changed over time- so has our ability to save for our financial independence.
Since the 1980’s, the 401k has been one of the most popular savings vehicles for Americans attempting to save for their retirement. But financial conditions have changed a lot since the 1980’s, and will in our opinion, most likely change in the future. Your 401k plan could be the equivalent of a television with only four channels and no remote control.
This doesn’t mean a 401k plan is a bad choice for savers, though, but it does mean you need to take it off of auto-pilot and think about how you are using this vehicle in relation to your other choices. Let’s start off with the positive factors of a 401k plan. First, as most people know, it is an automatic investment vehicle that can easily be set to help you “save first” by taking money right from your paycheck each pay period. There are also some tax benefits to 401k plans that can be attractive to participants. Finally, many employers offer a match on what employees contribute to their plans or may even make a contribution on behalf of the employee.
But there are many challenges with 401ks that can work against an investor. The first, and most obvious, are the often a smaller number of investment options allowed, and often the fees associated with those investments. Higher quality and less expensive investment options may be available outside of your plan. Many people also know a 401k will allow a reduction in taxable income for you now, as well as tax deferral until you take your money out. However, a lot of the benefit of this strategy comes from the belief that the participant will be in the same, or a lower tax bracket in retirement. This may not be the case. Good investors and savers often find themselves in a similar, if not higher bracket in retirement. And, since the 1980’s, top tax brackets have come down. Given the possible financial pressures on the US financial system, in our opinion, it is possible tax rates may have to increase in the future. This means participants may be getting a tax deduction now, only to pay a larger share of tax on income taken from the plan in their retirement years.
Another issue with the 401k plan, particularly for high income savers and investors, is that participating in a 401k may not be enough, but the process gives participants a false sense of security. A person with income of $195,000 who puts the maximum contribution into their 401k, may only be saving only 10% of their income or less. For financial independence, the rate of savings, would most likely need to be higher, and in many cases, much higher, for this person to sustain their standard of living throughout their lifetime.
How do you make a 401k plan work best for you? We suggest thinking about our decision process.
If your plan has a match on your contributions, or a straight employer contribution on your behalf, it is probably a good, if not great, idea to participate at least to the level of the match.
Consider fees and investment choices next. If fees are punitive and investment choices are questionable, you will want to weigh that carefully with what you can do on your own. When comparing to outside IRAs and ROTH IRAs, however, be sure to check with your CPA to make sure your income or participation in a 401k plan doesn’t prevent you from using those choices.
If your plan has a ROTH feature, which would allow you to invest your dollars in a ROTH portion of the plan (even though an employer match is deposited in a separate pre-tax portion), this may also be a better choice for you than the pre-tax option. A ROTH option allows you to not get a deduction for the contributions now, but instead, allows the contribution, as well as the possible growth of the contribution to grow tax free, instead of tax deferred. This is an incredibly attractive option to high income participants, or for those who believe they will be in the same or a higher bracket in their retirement years. Younger participants can really benefit from this due to the many, many years of possible compounding. But older workers who need to diversify their assets from a tax perspective can also benefit from this option. When you leave your employer, these also can be rolled into ROTH IRAs, which have benefits that traditional, pre-tax IRAs do not have.
From a choice perspective, think about your other needs and resources. If you are participating in a 401k plan, but have no real savings (we typically recommend six to 12 months of living expenses), you could be putting yourself in jeopardy. If you have a high income, are you saving and investing enough in addition to your 401k plan to reach your goals? If you are nearing financial independence and still putting money in a pre-tax 401k, are all (or most) of your resources going to be pre-tax in retirement? If so, you may want to seriously consider diversifying those last savings contributions, so you have other tax laws to work with beside the qualified account one.
Finally, and just as important as when you are deciding to contribute to your 401k plan, think very carefully about what you do with your plan after you leave your employer, or when you have a chance to do a an in-service withdrawal. It’s a broad enough subject for an entirely different article, but there are lots of mistakes and missed opportunities for people who do not evaluate this important step correctly.
There is nothing wrong with a little television with a few, reliable channels to choose from. But when you add many more channels, a remote, and give it the power of the internet, you have access to so much more. The same is to be said about your 401k plan, so take the time to really evaluate how you are using it.