Not investing in your 401(k) sounds like heresy. The tax benefits of investing in these retirement programs are numerous. Employers often match contributions up to a certain amount. This is ‘free’ money outside of your obligation to work for that employer. If your match vests over time, it becomes a lever to keep you at your job. Your contributions are not taxed. If you max it out each year that can save you up to $6,000 a year. 401(k) plans are also shielded from creditors in the worst case scenario.
If we assume the returns are the same inside and outside a 401(k), the actual money you get to keep is the same. A 401(k) appears to grow faster due to having more tax-differed principal. That portion of growth still belongs to the tax man. You just defer the payment and grow it for him. So why is there $54 Trillion in 401(k) plans in the US? The real win for a 401(k) lies in the assumption that when you take your distribution from it later in life, your tax rate will be lower than when you put the money in. A 401(k) allows you to save the difference in the tax rates between when you deposited and when you retire.
Example 1 – Tax bracket goes down
Let’s assume you are in the 28% tax bracket when you make your contributions to your 401(k). You invest $100,000 in your 401(k) over your working life and it grows to a value of $500,000 when you retire at age 60. Now when you take your distributions your tax bracket is 15%. If you draw $40,000 per year, you pay $6,000 in tax.
This is where your 401(k) pays off after 40 years of working a day job. How does that tax savings feel? Was the trade worth it?
Example 2 – Tax bracket stays the same
If we assume that you stay in the same tax bracket when you retire by spending at the same level, then you are paying tax on those gains just later. There has been no real benefit to the 401(k) except the employer match. That $100,000 went in, it grew to $500,000, and you pay 28% on all the money that came out of it, the same you would have if you just invested it outside a tax deferred account. So the best way to make this plan a win involves
- Lowering your annual spend when you retire to a lower tax bracket than when you were working
- Not being able to access the money until you retire at the age of 60 or later. Great you’ve got a $2M 401(k), you’ve lost your job, sorry you can’t touch that money! (Actually you can, but that is for another post)
- Assume that tax rates do not go up by the time you retire. An increased tax rate could nullify a 401(k) completely.
Time is your best asset
Here is the worst part. Let’s assume you lower your spending and withdraw the money at the lower tax bracket. Great, you’ve got the employer match and the growth that came with that as well. Now you are 60. Anything you want to do with that money you have to do with a 60 year old body. This is why we should all stay in great shape to extend our useful lives as long as we can. However, trips around the world, time with our friends, adventures, or even access to the cash are going to be significantly different experiences when you are in your prime. The reward of all of that savings is simply being able to use the money later which isn’t much of a reward.
If you want to reach independence while you are middle aged, or even young, your 401(k) is not going to help you do it. It will help you become secure when you are old.
If you become an investor early in life, you are going to see a lot of deals and opportunities. If your cash is locked up in a 401(k) you will not be able to take advantage of them. A 401(k) is a great place for a long term balanced stock portfolio to grow for 30 years. Properly balanced it will yield around 8% – 10% if history is a decent indicator.
There are many opportunities in real estate and business investing that can yield 15% or more with good downside protection. In order to participate in those, you are going to need liquid cash that you can invest with. Businesses also come with a whole host of tax benefits that can exceed those provided by your 401(k) deduction. Money that you invest outside of a tax shelter also isn’t taxed at 1% per year by a money manager either.
Ask yourself who you know that is financially independent or doesn’t work any more than they have to. Did they get their with their 401(k) or did they build a business? A tax deferred retirement account is a great asset to have for later, but it is not a vehicle to reach financial freedom. It’s a perk when you hit 60 at best and only if you plan to be in a lower tax bracket.