Putting money in a 401(k) is the right thing to do, isn’t it? Yes! No! Maybe? Surprisingly, the answer to that question may not be as simple as it seems.
What is a 401(k)?
In the late 1960s due to market volatility and the realization that life expectancies were increasing, large corporations began to re-think pensions. The 401(k) was born after Congress introduced the Revenue Act of 1978, which added permanent provisions to the tax code allowing the use of salary reductions as a source of plan contributions. Throughout the next couple of years, several companies developed 401(k) plan proposals and by 1983 more than seven million employees were participating in a 401(k) plan.
Advantages of 401(k)s
- Automatic savings – The money is taken directly out of the employee’s paycheck. This can be a great feature for someone who has a hard time saving.
- Employer match – Many employers that offer 401(k)s will offer a match of up to six percent of a salary. Some consider the employer match to be “free money” that should be used to its fullest advantage.
- Tax deferred – For traditional 401(k)s, the employee contributes with pre-tax dollars keeping their taxable income down. The money also grows tax deferred with the idea that when the person retires and takes income from their plan, they will be in a lower tax bracket and paying less in income taxes.
Disadvantages of 401(k)s - What to consider
- Market fluctuations – Money held in 401(k)s is mainly invested in the stock market. In the past 15 years, the stock market has experienced two major corrections. Between 2000 and 2002 and 2007 and 2008 the market decreased sharply, and so did the account values of 401(k)s. The 10 years before you retire and the 10 years after you retire are what I call the red zone. If your account experiences as much as a 20 percent loss during your red-zone years, the odds of your account running out of money during your retirement years increases substantially. This is called the sequence of return risk.
- Tax savings – Another issue with these plans is whether or not they will actually save you money on your taxes over the long run. The top income tax rate today is 39 percent. If this number goes up, which many people believe is probable, then you could actually wind up being in a higher tax bracket at retirement than you were when you were working. This could result in 401(k) plan holders having to pay more taxes over the long run.
- 401(k) fees and cost - A 401(k) can be an expensive employee benefit with two types of charges levied on employees investing in a company’s plan: investment management fees and administrative cost. Investment management fees are ongoing charges to manage the funds in the account and are generally the largest recurring cost to employees, assessed as a percentage of assets invested. Administrative costs cover the day-to-day operation of a 401(k) plan that are necessary for administering the plan as a whole and include record keeping, accounting, legal services and other costs to run the plan. While companies are starting to bring these costs down, high fees are still a major concern often eating away at these accounts, particularly those offered by small to medium sized businesses who do not have the bargaining power of large corporations.
Should you contribute to a 401(k)? Yes? No? Maybe? If your employer offers a match, it could be a good idea. But if not, there are many things to consider when saving for retirement including sequence of return risk, taxes and fees. This is a lot to think about. No single account should be your sole retirement plan. Explore your options with the help of a qualified financial professional.
Rick Foster, president and founder of Guardian Financial Management, is based in Lewisville and specializes in building comprehensive retirement plans. He hosts the weekly radio show Plain Talk, No Worries on Legends 770 KAAM Mondays at 3:30 p.m. and Saturdays at 12:30 p.m. and 660 The Answer KSKY on Sundays at 7 a.m.
For information call 972-996-7858 or visit www.guardianfinancialmanagement.com.
Investment Advisory Services offered through Brookstone Capital Management, LLC. (BCM), a SEC Registered Investment Advisor. Guardian Financial Management and BCM are independent of each other.