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Many people say that 401ks are one of the best ways to save for retirement, including myself. With growth similar to other retirement funds and employer matches which are essentially free money, what is the downside to 401ks? Although there are many advantages to these retirement plans, there are many downsides.
Some people may say that they know there are some problems with 401ks, but 401ks have multiple problems, and some I did not even know about until recently. In fact, there are enough problems that many people including, Grant Cardone, say we have been investing in a 401k scam.
Claims Of A 401k Scam
There are multiple reasons people claim we are investing in a 401k scam.
1) Tax Deferral Is Not The Best Way To Grow Your Investments
Most 401k plans invest in retirement similar to a traditional IRA. Traditional IRAs are tax deferred, not tax free. That means your contributions get a tax write off. For instance, if you make $50,000 a year and you invest $10,000 in your 401k the government will tax you like you made $40,000 that year. This will lower the taxes you need to pay up front, and sometimes even lower your tax bracket. This would be the best tax avoidance advice in the world. Except, the gains are taxed. Furthermore, with the consensus being to tax the rich, people have been seeing their retirement accounts, which they have worked hard for some many years, be devoured by the government.
2) 401k Match
Yes even the “free money” given by the employee match comes with a price. The matches do not set in until years after you start your contribution. There are multiple other hoops to jump through to get these matches. Unfortunately, matches can also change or disappear at any time.
Despite potential fall backs, the 401k match is all but free money and can increase your investments by 50% straightforward.
3) Not Very Liquid
First, let me say one thing quickly. Retirement plans are not supposed to be liquid. You should not be able to easily remove money. Trust me, you do not want other people easily moving your retirement fund.
That being said, there are multiple issues with transferring your 401k in the event of a change in employment. You will be limited in where you can place your retirement fund or even control its allocation. Simply put, you cannot change the assets in a 401k as readily as you can in a typical IRA.
4) Lack Of Options
Roth IRAs and traditional IRAs are well established portfolios in which you can put practically any asset in it. Unfortunately, 401ks are not the same. You will have a limit of potential funds to set in your 401k and limited allocation potential.
5) Administrative Fees
People buy the whole 401k scam claim mostly because of administrative fees. Fees are impossible to avoid in investing. Some have next to no trader fees under reasonable conditions. For instance, many index funds have expense fees of only a fraction of a single percent. I know many that have less than a 0.1% expense percentage (check out Vanguard, they are not paying me to say this [yet], they are just such a great brokerage firm). Some actively managed funds have a higher expense percentage, but I am invested in a balanced fund which has less than 0.5%. On average the percentage taken from your investments is 2.2% in a 401k. In other words, if you invest in an S&P 500 fund (assuming they have one) with your 401k instead of average yearly gains of 7% (inflation adjusted) you will only see your accounts increase by 4.8% annually.
Altogether Fees Lower Gains
Unfortunately, the gains of 401ks are heavily negated by the fees. The fees will lower gains to 4.8%. Even with the company matches, a typical Roth IRA with low expenses will outpace the growth of the same contributions and growth compared to a 401k. You can see this in the chart below projecting investments starting with $20,000 and contributions of $2,000 annually. 401ks have the employer contribution of 50% from $2,000 of the employee contribution for a total of $3,000 in contributions (optimistic but realistic).
401ks have limited assets and allocations compared to other retirement accounts. Furthermore, limited tax benefits and fees that negate the benefits of an employee match to the point where a Roth IRA will outpace a 401k in the long-term. There are only three reasons I would say that a 401k would be more beneficial compared to a Roth IRA. That is if the plan allows for the use of a Roth 401k with the advantage of having tax free gains, if the plan has a 50% employer match, and if the administrative fees are less than 2%, preferably around 1%. There is good news, according to the ICI, 401ks have decreasing expenses. Some are as low as 0.53% (I have not seen any that low though). Altogether, many, if not most, Roth 401ks can outpace a Roth IRA. Otherwise, a Roth IRA would be the better path to go.
So with fewer benefits, does that make a 401k a scam? No. A scam implies that you give people money and they have no intention of giving you anything you want. The assets you invest in with a 401k will have gains.
Here is my opinion. Back when 401ks started, they were a great retirement plan. That being said, the 401k was popularized in the early 1980s, just before personal computers and internet access was common, just before anyone could make a retirement account with a few clicks. Therefore, it was less convenient to set up a retirement account a few decades ago. You would otherwise have to call to buy and sell your assets, (and that is the convenient way) the 401k paid someone else to do that for you and helped streamline it. Now that computers and the internet are readily available, managers do not necessarily need to be paid as much.
How To Use A 401k right
Traditionally managed 401ks are not scams, but they may be becoming obsolete. However, with more options now, lower fees, and the addition of Roth 401ks (hybrid of 401k and Roth IRA) 401ks are not very traditional anymore and are adapting to modern times.
It is worth mentioning there will still be fees and limited options. Ask your employers about both of these, make sure the fees are reasonable and that there is a broad array of assets you can invest in. If these are good, then you should start out a Roth 401k, but you should only contribute the maximum that your employer will match to. Expenses on any 401k will be higher than a Roth IRA or traditional IRA made at a discount brokerage. After you invest enough to reach the employer match maximum, you should contribute exclusively to a personal Roth IRA.
I Do Not Like Fees Are There Alternatives?
I have mentioned investing directly into a Roth IRA, but if you do that there will not be an employer match, right? Here is the thing, many employers have to negotiate and pay to keep a 401k. If they are in the business of making profits, or at least maximizing what their organization does, they will not enjoy the effort and resources that go into these 401ks.
Jaspreet Signh of Minority Mindset, one of my favorite financial gurus, and entrepreneurs started a new idea called an investment match. Instead of setting a 401k plan, he sits down with his employees, and learns about how they want to invest their money, sometimes in an IRA. Then he asks for documents which show how they contribute to their own assets and matches it to a certain extent. It’s essentially a 401k without the middle man and with the investor having full control. Will your employer agree to do this? You never know unless you ask.
401ks are not scams, but POTENTIALLY good investment options. You just need to be smart to maximize your gains, but over-contributing can minimize those gains. Ultimately, you must use several sources of investment opportunities including a good Roth 401k (when available) to forge your wealth.