Are 401k’s really the best thing since sliced bread?
Isn’t getting a 50% match a 50% rate of return for free? Who doesn’t want free money, right?
What has experience taught us?
401k’s offer little to no benefit compared to what you can do on your own. This is especially true if you’re an entrepreneur!
Let me explain….
I’m going to get down & dirty on this one because I have a lot of evidence to back me up, and there is a lot of guessing about how good 401k’s really are. The only valid point that people give me about 401k’s is the employer match. In my opinion, this is a good thing. It’s a bonus if they give it to you when you don’t put anything in. I love that!
What About Tax Benefits?
Some try to make the point that there are tax advantages. THIS IS FALSE! You still have to pay taxes someday.
If you’re an entrepreneur, there are no advantages to matching your own contributions unless taxes went down in the future. Do you really think taxes will go down in the future? Then why delay paying those taxes? You don’t even get a write-off if it loses value! If we lose money in our businesses, at least we get a write-off for it!
What I don’t love is what the 401k actually costs YOU! Most people don’t realize there are fees coming out all the time. It’s very common to have fees totalling 2-3%/yr or higher! In fact, your 1st quarter statement will finally show some of this. If you want to see a lot more details on the many fees, read my blog I wrote 3 years ago on this subject.
So don’t you make a 50% return? Good question. Let’s take a look.
Let’s assume you contribute $200/month and get a 50% match ($100/month):
In one year, you put in $2400 and they match $1200 = $3600. I’m not including fund returns because that isn’t the variable here. You can make those returns outside of 401k’s. If you factor in 2.5%/yr fees taken out monthly, you would have $3551.06 because $48.94 of fees were taken out. Now, that IS still a great return!
Here’s where it stinks:
In 5 years, you would have $16,889.46 after fees. If you decide to cash out (assuming you’re 59 1/2 or older at a 25% tax rate), you’d be left with $12,667.10. That return only averaged you 1.09%/year, not 50%!!! If the taxes are 30%, then you are in the negative!
Why does this happen?
Because you pay fees (and eventually taxes) on the entire amount, but only get matched on the new money. It’s great in the beginning, but doesn’t even pay the fees after several years (not including taxes you have to pay on the match too). See my point?
If you’re still not convinced, NBC News did a great article how a 401k will cost your family $155,000! For further proof, one of my clients who did the full match for 25 yrs (1985 – 2009) came up with a whopping 4.9% real rate of return, including the match!
If you’re an employee – Look into paying off your credit cards and higher interest loans first. Once that’s done, a 401k may be good for you, but be willing to look for putting money elsewhere.
If you’re a business owner – look for other ways to generate cash flow in your business and save the profits in safe, guaranteed places (such as business savings, CD’s, annuities, or whole life insurance) where there can be tax advantages, but it’s not too hard to get to in case of emergencies or opportunities.