Why maxing out 401k is not as great an idea as it sounds

Question 401k like L would from Death Note

Question 401k like L would from Death Note

In 2013, the maximum contribution is up to $17,500 while it’s an additional $5,500 for those 50 years or older. Everywhere you go on the interent, you can read articles recommending to contribute maximum to your 401k. It frustrates me to hell that people easily make such recommendation, so I’ll jump straight into my stance…

By all means, anyone should contribute enough to get all of the company’s matchings if the company does that.

Beyond that, I argue that contributing maximum to 401k plan may not be as good an idea as we think!

Below are my reasons:

  • 401k is illiquid until you’re 55. That is when you can withdraw without penalty. Until then, you can only take a loan which you will have to pay back (to yourself with interest) to access the money without penalty. At the same time, most 401k plans only allow withdrawal when you leave the company. Illiquid money may equal opportunity cost for other investment opportunities.
  • 401k has management fees, service charges, etc.. Depending on who the company hire and how big the 401k plan is, fees vary but any kind of fees will reduce your rate of return.
  • 401k’s investment will encounter selling pressure. I already mentioned 401k is illiquid and you may only have a very limited amount of investment choices in the plan. In such a case, you can get stuck holding onto investment that will continue to drop in values because population is aging and there will be more people trying to sell investments to retire than ones joining the work force.
  • 401k investmnt loss is not tax-deductible. Loss deduction is a nice tool to have for managing your investment.
  • 401k is tax-deferred, not tax free. Income tax is 25% or below for much of the population. Capital gain tax had been at 15% is now at 20% and will likely remain lower than income tax in future. Looking at our government debt, future income tax will likely be higher… much higher. Do you really want tax-deferred (AKA paying the higher income tax rate in future)?
  • A Math example…
    401k_math_1

    Here I show the result of someone contributing $5000 yearly and growing it over 30 years in a 401k vs. taxable account. I use 7.5% growth rate for 401k to account for some fees. To simplify, I took the tax out using the “Tax Rate in Future” at the end, and it implies future income tax for 401k and future capital gain tax for taxable account. So for 401k, I subtrated out 25% income tax while for taxable account, I subtracted 15% capital gain tax from just the gains to get the totals. This result tells me that the advantage of a 401k account is minimal and cannot outweigh the disadvantages mentioned. I provide a few more math results by changing the variables at the end of the post.

  • Last but not least… you may die soon. If you know you will die in a few months but your money is stuck in 401k… you are shit out of luck accessing it without paying penalty+tax. This one maybe a bit of a stretch. But hey, it’s worth thinking about!

The final take away is, maxing out 401k is really a personal preference where it is hard to say if it’s truly the best option for planning retirement. Assuming you can implement the same investment strategy, the advantage is minimal while there are disadvantages and more unknowns in the futures due to the 401k money being tax-deferred.

Personally, the advangages and disadvantages are largely a wash so I’d rather have flexibility controlling my money in taxable accounts and not have it locked up.

At any rate, what I really am saying is that each of us needs to understand thoroughly before jumping on the max-out-your-401k wagon.

We didn’t talk about Roth IRA here but it is likely a better option to put money into Roth IRA first vs. maxing out 401k. Also, having a taxable brokerage for investment should also be considered and done in junction with 401k, Roth IRA, etc.

All of us need to have saving/investment vehicle outside of 401k because let’s recall, 401k was created as a supplemental vehicle to help us save for our retirement — not the only thing we use.

More Math examples with varying parameters and results:
401k_math_2
Rate of return for 401k is 7% to simulate more fees.

401k_math_3
Rate of return for 401k is 7% to simulate more fees and future income tax is increased to 30%.

401k_math_4
Rate of return for 401k is 7% to simulate more fees. To simulate tax increase across the board, future income tax is increased to 35% and future capital gain tax is increased to 20%.

401k_math_5
Rate of return for 401k is 8% assuming a good plan with minimal fees.

401k_math_6
Rate of return for 401k is 8% assuming a good plan with minimal fees and future income tax is increased to 30%.

401k_math_7
Rate of return for 401k is 8% assuming a good plan with minimal fees. To simulate tax increase across the board, future income tax is increased to 35% and future capital gain tax is increased to 20%.
Rate of return for 401k is 7% to simulate more fees and future income tax is increased to 30%.

Originally posted 2013-01-16 01:13:55. Republished by Blog Post Promoter

One Response

  1. I’m still new to the game myself but what I’ve gleamed is you have 3 factors in growing your retirement account. Time, amount of contributions and your rate of return. There might be others, but again I’m still learning myself. Time is on your side since you still have 30 years before you retire, you can extend your work time if you need to. Hopefully you’ll be healthy enough that you can extend your working career if you have to. Increase your contributions. That might be tough if you’ve got a lot of bills or debt. Maybe get a part time job and use that money to increase your contributions? Cut extra bills that aren’t necessary. If your rate of return isn’t what you’d like, then maybe change it to something more aggressive? Does your 401k have “target date funds”? That might be the simplest way to do it since they automatically change your allocations. So if your target retirement age is in the year 2040, then pick a target date fund close to the time. It will be more biased towards stocks now while you have a longer time horizon, then will switch to more bonds as you get closer to retirement age. Since stocks are riskier, they should give a better return.

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