Should I participate in a 401k? Is a 401k right for me?
(Approximately a 5 minute read.)
In making the decision it is critical to know how Federal laws, and the laws of personal financial economics, affect you. Participating in a 401k, IRA, or similar plan can be a benefit or a large and costly financial error. There are several basic factors to consider:
1. There is no current tax saving; therefore, no increase in net money supply, obtained by participation. The amount put into the plan includes the tax that would have been paid had there been no contribution. It is a zero-sum financial action until the costs on withdrawn money are calculated.
2. You defer the tax and you defer the tax calculation. There is no way to avoid tax payment when the money is taken out, whether one day or many years later. The tax rate that will be paid will be the rate in effect at the time the money is taken out. The amount taken out in any year is added to the total of all current income earned in that year; perhaps creating a higher taxable income and tax rate.
That commonly happens since, generally, there are fewer deductions available later; and, when adequate income is taken from the plan to live comfortably in retirement. This can create a higher tax rate at the time the money is taken out than would have been paid when the money was earned.
For those with retirement/pension benefits as typically found in the public sector, adding 401k or similar plan income to the pension income, and any other income, will almost certainly create a higher tax rate than would be paid if there was no plan participation, making it a negative sum financial action.
3. During the accumulation years there will be times when a pressing financial need or want arises. Taking the money out of the plan creates tax and penalties that can wipe out the growth that was earned, and more. The Federal penalty is 10%. Most states also add a penalty. Every year billions of dollars of tax and penalties are paid to the IRS for this reason.
4. If a 401k loan is taken, it must be repaid within 5 years or it is deemed a withdrawal and assessed tax and penalties. Job change, job loss, or layoff present a serious risk of the tax and penalty becoming payable.
5. 401k loan repayment is made with after-tax dollars. The plan does not recognize or account for that. That after tax money will be taxed again when taken later, causing multiple taxation.
6. The money in the 401k is unavailable and unusable without either the tax and penalty or the multiple tax problems. This creates “loss of use” costs. Financial wants and needs go on; so, to avoid tax and penalty, there is increased use of credit cards and other debt. Debt interest costs offset plan earnings. Credit card interest rates alone are far higher than plan earnings rates.
Cash flow analysis commonly finds that more debt interest is paid out each year than is being earned in the 401k or similar plan each year, creating a net overall loss because money is locked up.
When interest is paid out, there is the interest cost plus Lost Opportunity Cost on the interest paid. (Opportunity Cost is explained in our video “Hidden Wealth – How to Capture the Hidden Financial Power that Exists, Right Now, in Your Cash Flow”). Because it is paid to a bank and gone forever, all the future compounding that could have been earned on that money, if it was kept, is lost as well. That is Lost Opportunity Cost.
7. Living frugally, minimizing withdrawals to save taxes, has its own tax trap. When death occurs, whatever 401k money is left in the plan (any money you have not taken out and paid taxes on), can provide continuing taxable income to a spouse. If there is no living spouse, it will go to children or other heirs in a lump sum. The size of the lump sum can put that money in the maximum tax bracket. Total state and Federal taxes on the lump sum can easily equal or exceed 50%.
If the surviving spouse takes it as a lump sum, the maximum tax, or at least a higher tax, can occur. Maximum tax, as opposed to saving tax, is a common result. If life insurance is still in effect at that time, it can absorb all participation costs making coordinated planning highly beneficial.
All of this can be calculated and measured beforehand to help make the best decision. When participation creates higher taxes, debt costs, and Lost Opportunity costs, the end result of 401k participation can be deeply negative. A true net loss.
Where we see participation at the greatest advantage is with high income earners at a high current tax rate who are likely to have a substantially lower future income, and therefor a lower tax rate, when distributions are taken. Provided, of course, that the Federal government does not increase the tax rates. The lump sum distribution at death remains a serious problem so good planning around participation is essential.
A major consideration for anyone is this: when the primary form of savings is locked up money, the risk of having negative results is high; almost certain.
We are consumers cradle to grave, with never ending wants and needs to pay for over our entire lives. For participation to be a benefit for anyone, lifestyle costs, present and future income taxation, potential lump sum taxation, interest costs due to loss of use of your money, life insurance, and Lost Opportunity Costs must be accounted for to properly evaluate the decision. Combined, those costs offset and can exceed plan growth and a company match (if there is one). Yet, with sound economic strategy, those costs can be largely avoided or recouped, making participation a far more favorable experience.
Our free cash flow analysis will lay out your options clearly to enable you to make your best decision.
Sincerely,
Michael Burrill