4 Reasons to Avoid the 401(k) Money Trap

If your company offers a 401(k), it is certainly tempting to participate in it. 

The big selling points are the company can match your contributions (up to a predetermined percentage) and the earnings on your money accumulates tax-free.

Also, the company will let your side of the contributions come out before your paycheck. This way, you don't have to declare your contributions as a taxable income event each year.

Finally, if you take full advantage of their 401(k) plan you can potentially contribute as much as $56,000 per year (combined total between employer and employee).

Employees over age 50 can contribute an extra $6,000 for a possible contribution of $62,000 in 2019 (each year, modest increases are made in maximum contributions).

So, why not go all in each year with maximum contributions so you have a large 401(k) at retirement?

Here are four important reasons you should avoid the 401(k) money trap…

1. Expensive Fees in 401(k) Plans

Most 401(k) plans include fees based as a percentage of assets.

These fees can range between 0.5% and 5%.

If your 401(k) investments are in bank certificates of deposit (CD), the guaranteed interest rates run between 0.35% and 2.2% depending on the maturity of the CD.

It doesn't take a rocket scientist to figure out that a 1.5% earnings on your investments with fees running at 2% will mean you are actually losing money each year!

Okay, then perhaps you need to be more aggressive in your investment selections.

It's a nice thought, but you don't have control over how those funds are invested. The plan's administrator decides how to invest all funds, choosing the type of investments they think are best for the 401(k) plan.

2. An Illiquid Position

When you put away money in a personal savings account, or even in investments, you have control over when to sell (i.e., liquidate) assets, converting them to cash.

Unfortunately, all the money you stow away in your 401(k) remains locked until either you retire or you leave the company.

Even worse, if your 401(k) plan has invested in assets lacking liquidity, getting out of it means selling it at a loss.

Under a true emergency, you can withdraw funds early (before age 59 1/2) but you will be penalized twice for doing it.

First, you have to declare those withdrawals as taxable income. Plus, you will be assessed a 10% penalty. This could wipe out all earnings and more within your 401(k) plan.

One more situation where a lack of liquidity can become a headache is at age 70 1/2.

At this point, you are required to start withdrawing funds from your 401(k), whether you need the money or not. (They literally force you to kill your cash cows. Learn to milk them instead, here.)

So how much must you withdraw at age 70 1/2 and older?

The IRS offers a life expectancy table.

Find your age on the table and it will tell you how many years you expect to live (on average, of course…no one is a mind reader!).

Dividing your total 401(k) balance by the life expectancy number tells you how much you must withdraw at a minimum.

For example, let's say you have $1,000,000 in your 401(k) at age 70 1/2.

According to the life expectancy table, a person aged 70 1/2 lives 27.4 years longer on average.

So, divide $1,000,000 by 27.4 and you get $36,496.35, your minimum required withdrawal.

3. Starting From Scratch at Retirement

As crazy as it may seem, once you reach retirement, depending upon the investments placed in your 401(k) plan, you may need to convert non-income producing assets into investments producing income

So, essentially you start from scratch at retirement and have to decide how to create an investment portfolio to generate income. (You know that's what we do here, right?)

Hopefully, this income will be enough for you to maintain the same comfortable standard of living.

The big bummer is that you are being hit with taxes on those 401(k) withdrawals.

This potentially leaves you with a smaller investment portfolio to generate the income you need to live.

For instance, let's say you wait until age 70 1/2 to start your withdrawals and further assume your 401(k) is worth $1,000,000.

As I explained above, your withdrawal would be $36,496.35.

If you are in a 20% tax bracket, that means you owe $7,299.27 in taxes on that withdrawal.

That leaves you with $29,197.08. Dang!

4. Saving, Not Investing

The final reason (and it is huge!) for avoiding the 401(k) money trap is that it is essentially a forced savings program disguised as an investment.

Also, all those years you were working at stashing away money for retirement, you have gained zero experience or knowledge about investments and yields.

This leaves you at square one when it comes to investing.

You face a difficult learning curve that would have been avoided had you decided to handle your own investments along the way instead of leaving it to your employer. In fact, your employer is likely equally inexperienced about selecting investments.

On top of all that, it is probably the lousiest method of saving for retirement because:

  • All of that money will be taxable when needed for retirement.
  • You are paying large administrative and management fees each year. This cuts into your total savings, possibly costing more than your investment earns.
  • If you are forced to sell stocks when the market is down, you can see the total value of your retirement savings drop at the worst possible time.
  • You are left with the problem of converting your assets (sometimes at a loss). At the same time, you're being hit with income taxes and finding good yields for the remaining amount.

A Realistic and Viable Retirement Plan

Now you know why you don't want your money trapped in a 401(k) plan when you want to retire, so what is the best alternative? 

By learning how to invest, not save, your money, you will be well prepared once your retirement years arrive. By paying close attention and committing to a serious, sensible investment plan you could even retire earlier than expected.

Bottom line: Plan ahead and rely on the power of compounding earnings over time.

These 401(k) gimmicks to save taxes and shelter investment earnings will reveal themselves to be tiny bells and whistles on a potentially disastrous retirement fund.

Even if the investments grow at a decent rate, you still face some or all the problems described above.

If you are serious about your retirement plan (and you should be!), take matters into your own hands and learn how investing for income can help you build a respectable portfolio that actually will help you enjoy your retirement without stress or reducing your lifestyle.

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