Why are 401(k)’s a bad idea? Why don’t rich people use them? And seriously, are they worthy of being called a scam?
There are more than a few reasons that 401(k)s are a bad idea, including that you give up control of your money, have extremely limited investment options, can’t access your funds until you’re 59.5 or older, are not paid income distributions on your investments, and don’t benefit from them during the most expensive period of your life (child-rearing years).
Did I also mention that your 401k account value may plummet—it happened in 2008 and could happen again.
Oh, and you won’t be able to deploy funds into high return investments like real estate.
Plus, you’ll have to pay hefty fees to the folks on Wall Street. Yes, they’ll collect between 1-3% in fees from you every single year. That will be an estimated $138,336 over your lifetime. Yikes.
Don’t forget to add inflation on top of that too. Inflation will eat away another 2-3% of your gains every single year. So, until you make at least a 6% return, you sadly haven’t made much headway beyond paying off your 401k management fees and keeping pace with inflation.
Then, there’s the dire fact that your 401k withdrawals will get taxed as ordinary income, making them subject to state and federal taxes at the time of your retirement.
Today, the highest federal tax rate is only 37%, but it has floated as high as 94% (1944). There were also three decades (1950s, 1960s, and 1970s) where the federal tax rate never dipped below 70%.
Do you really want to roll the dice on what tax rate you’ll pay at retirement when today’s rates are some of the lowest in the past 100 years?
That list is just the tip of the iceberg for why 401(k)’s are a questionable tool for wealth building and almost never used by the wealthy as a strategy for financial expansion.
Why Examine the 401(k)?
Why am I writing about 401k’s? The short answer is that it is a fascinating subject.
As we explore it, you’re more than welcome to listen and learn or you’re welcome to ignore my perspective. I have no agenda here, nor anything to sell.
I simply want to educate you about the facts, share some history, and explore the myths you’ve likely been told by the people around you. Then you can decide.
What may be noteworthy is that I’ve been studying the tax code for decades, read books about this topic in my spare time, and regularly dig through the dreaded IRS tax code which is an estimated 74,608-pages long.
Thankfully, the online version of the tax code lets you search by topic. Phew!
However, if you’re not keen to believe me, you can also listen to financial experts like Grant Cardone or James Altucher, who share my perspective that 401k’s are a scam. In Grant’s words, “The 401(k) is merely where you kiss your money away for 40 years hoping it grows up.”
As James puts it, “[401k’s] are scams. This is another trillion dollar industry that has a lot of money at stake if people stop believing in the mythology bolted to the scam… Then there is revenue-sharing between employers and 401k plan managers. Is this legal? Yes.”
I also created 7-figures of wealth by my early thirties, own a portfolio of residential and commercial rental properties, and traveled the world playing National and International Rugby, all paid for by business assets and income-producing investments. I’m not saying that I’m Bill Gates, but I certainly know a thing or two about how to create financial freedom and smart tools for achieving it.
What created financial freedom for me was not money within a 401k that I can’t access for decades.
It was cash flow from assets and investments that pay me today. With that context, should we get started?
What is a 401K Plan?
A 401(k) plan is a retirement savings vehicle offered by an employer to an employee. It lets the employee save a fraction of their paycheck and invest it without taxes being taken out first.
Instead, taxes are deferred until the money is withdrawn from the account when the employee reaches 59.5 years or older.
Originally, the 401(k) plan was set up so employees and employers could exclude a small amount of their salary from being taxable. They were also structured to allow employers to contribute small amounts, matching either some or all of the employee’s contributions.
Despite these small benefits, it’s critical to remember that any distributions – including your earnings – are taxable income when you retire.
Many of us grew up being told by our parents and peers that we had to invest in a 401(k) retirement plan. We were taught that 401(k) plans were the mainstay of our “generous employers” who would match our dollars to help us create a retirement nest egg.
Does a 401(k) make sense in today’s marketplace? The answer to that is a resounding…NO.
History of the 401(k)
There are many reasons why a 401(k) is a bad idea in today’s financial world. To understand why, it is important to start at the beginning.
In 1978, the United State’s Congress passed the Revenue Act of 1978, which included a provision — Section 401(k) — that allowed employees a tax-deferred way to receive compensation from bonuses or stock options. This law went into effect on January 1, 1980.
However, it was not until the early 1980s that the IRS began allowing employees to contribute to their 401(k) plans through salary deductions.
It was this change that created a country-wide shift from pension plans and toward 401(k) plans as a retirement strategy.
In an action that further solidified this new norm, the Pension Protection Act was passed in 2006 to “protect retirement accounts and to hold companies that had underfunded existing pension accounts accountable.”
A key part of that legislation was to move employees away from defined benefit pension plans, which provide a fixed payout for employees at retirement, and toward 401(k) plans.
The goal of this act was to keep existing pension plans from folding, in part by pushing people into 401ks. Because the Pension Protection Act of 2006 allowed companies to automatically enroll their employees into 401k plans, it further facilitated their rise.
From Pension Plans to 401(k)s
Large employers benefited dramatically from these new laws, because 401(k) plans are substantially less expensive to fund than pensions.
401k’s are also more predictable, because the employer is not responsible for making payments to retirees through death. 401ks don’t require the lifespan estimations that are central to pension plans.
In short, the 401k’s place the burden of retirement investing and taking distributions during retirement squarely onto employees. For the most part, this is healthy for our nation, because we should all want to take responsibility for our own retirement.
However, it means that most Americans are now relying on a system (the 401K plan) that hasn’t existed for even 40 years! Is this how you want to prepare for your financial future?
It’s not the approach that I’m taking. Below I explain the reasons I think 401k’s are an appalling idea.
Before I do though, let’s explore the (limited) upside they present.
Are 401K’s Worth It?
The positive things about 401k’s are:
- They’re easy to use – You may have been automatically enrolled by your employer.
- You may get some level of employer matching for your contributions.
- You could get a small decrease in your tax liability, reducing the amount you owe to the IRS.
- If your 401k grows in value, you defer your taxes until you make withdrawals at age 59.5+ years.
However, at the time of withdrawal, your 401k fund disbursements will get taxed and they will be treated as ordinary income under whichever income tax bracket you fall into at that time, with federal tax brackets currently ranging from 10% to 37% (they could go higher).
For anyone whose income tax bracket falls above 20%, this isn’t an ideal way to have your full 401K account taxed, because investments gains outside of a 401k would usually be taxed at a capital gains tax rate that would only range from 0-20% for long-term investments. Unfortunately, the IRS treats your entire 401K account (both the original contributions and any investment gains) as ordinary income, applying a federal tax bracket to all of it that could go as high as 37%. Of course, you’ll owe state taxes income taxes on it too.
However, I suppose if you’re not going to do anything else with your money or you’d leave it in the bank without investing it, then using a 401(k) is better than nothing.
At least then it won’t decay in value at the rate of inflation!
Why 401(k)s are a Bad Idea
Are 401(ks) a scam? In many ways, the answer is yes. There are 12 reasons that I believe the 401k to be more of a myth than a masterplan.
1. You Can’t Access Your Money until 59.5 Years Old
A big problem with the 401(k) is that you can’t access your funds until your 59.5 or older.
Meaning, they won’t provide you with any financial stability during your lifetime.
Notably, they won’t provide any financial support (income) during your child-rearing years, when your costs of living are at the your very highest.
2. Myth of the Employer Match
Often I hear the question, “Don’t 401k’s give you “free money”? I mean, what about the employer match?
Let’s think about this for a minute. Do you really think that your company is giving you free money? Where else in your life do you get things for free? Hmmm.
It’s quite simple, actually. Companies that don’t match 401k funds can pay higher salaries. The Center for Retirement Research did a study based on tax data and showed that for “every dollar an employer (on average) contributes to a 401k match, they pay 99¢ less in salary.”
The employer match is simply a reallocation of your existing compensation package and what the company can afford to pay you based on your skill-set.
Bingo! Employer matching myth debunked.
3. Oh, The Games We Play (Delayed Matching and Vesting Schedules)
Of course, many employers strategically delay their 401k matching for the first year of your employment and/or vesting schedules spread out over 4 to 6 years (six is the maximum allowed by law).
Let’s talk about delayed matching first. The Wells Fargo website states, “Wells Fargo matches your contributions—dollar for dollar—up to 6% of your eligible pay on a quarterly basis, after you complete one year of service.“
It’s a phenomenal deal for employers to install a delayed 401k matching. Why? Because, the average length of employment is now only 4.0 to 4.3 years (depending on gender).
By delaying 401k matching for one year when their employees stay only an average of four years, an employer like Wells Fargo eliminates its need to provide 401k matching for approximately 25% of its workforce.
Now, let’s talk about 401k vesting. A vesting schedule means that an employer may require a certain number of years of service before its matching contributions belong to the employee.
Depending on your 401k plan terms and whether it has a vesting schedule, your employer may be able to recover some or all of its matching contributions. In short, it will take back money from you if you leave your job too soon.
4. 401K’s Don’t Produce Income (Violates the Definition of an Asset)
As defined by financial expert Robert Kiyosaki, author of Rich Dad Poor Dad, an “asset is something that puts money in your pocket.” That is, an asset creates cash flow.
Have you noticed that your 401(k) plan never pays you are darn cent until you’re 59.5 or older?
That’s unfortunate, because there are a lot of income-producing investments that will provide you with cash flow (checks or distributions) throughout your lifespan, including but not limited to:
- Commercial and residential real estate
- Real estate funds like Cardone Capital
- Crowdfunding sites like Fundrise and Lending Club
- Peer-to-peer lending, which is act of loaning money to other individuals for set rate of return
- Tax lien certificates
- Income-producing businesses
- Even dividend paying stocks, mutual funds, and ETFs held outside your 401(k) account
5. Limited Investment Options
Another problem that I have with 401(k) plans is that they restrict you to extremely limited investment options. You typically can’t invest in specific stocks or bonds within a 401(k) plan. Depending on your employer, you’ll probably have to choose from a list of approved mutual funds and exchange-traded funds (ETFs).
You also can’t directly invest in real estate, which is one of the most powerful wealth building tools of all time.
The closest you could come to investing in real estate with 401k funds would be to roll your plan into an IRA and then use the proceeds. However, you’d still have to hire a real estate management company, because with real estate held within IRA, you’re not allowed to actively manage the property.
It is also difficult to use a 401(k) to directly invest in private placements, initial public offerings (IPOs), and other investment vehicles that could potentially pay you higher returns. A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on the open market.
The vast majority of 401(k) plans also prevent individuals from directly investing in precious medals, such as purchasing gold or silver bullion or coins. If you want to invest in gold or silver, you’ll probably have to do it through an exchange-traded fund (ETF) or mutual fund, of course, paying management fees to these fund managers along the way.
Put simply, you’ll only get access to “whitewashed” investments that are deemed suitable for the masses.
Meaning, at very best, you’ll get average results. Ask yourself, is that what you want for your finances?
6. Only Paper Assets (No Hard Assets)
A mentioned earlier, 401k’s evolved to help replace pension plans. A key difference between pension plans and 401ks is that because pension plans pool money from a large number of contributors, they control vast amounts of capital.
Historically, this has made them powerful institutional investors, a term that means they get to access investment vehicles with better terms and lower commissions.
It also means they have the bulk to invest in commercial real estate, a historically high performing asset class that is difficult for the average person to access and layered with compelling tax advantages.
As described above, 401k’s severely limit your investment options, typically limiting you to mutual funds, exchange-traded funds, and target-date funds. (No preferential terms or real estate for you!)
Unfortunately, these are all paper assets and not hard assets.
Hard assets contain actual value in the nature of the item itself, which paper assets do not. Can you guess which one tends to do be more stable during economic recessions and downturns?
Think about it this way: If there was a major recession in America and you were struggling to feed your family, would you rather own a dozen chickens and an apple orchard? Or, would you prefer to own a piece of paper saying that you had the right to a dozen chickens and an apple orchard?
Be honest with yourself, which one of the situations would have greater inherent risk, particularly during an economic downturn?
7. You Can’t Predict Your Future Tax Rate
Another crucial issue with 401k’s is that you can’t know what your tax rate will be at age 59.5, or for that matter, at age 70, 80, 90 or 100. This puts a quite a wrench into the “tax-deferred” argument, whereby some people suggest that it’s better to defer income taxes into the future.
First, as mentioned earlier, 401k withdrawals get taxed as ordinary income, and are therefore, subject to state and federal taxes. State taxes can go as high as 13.3% (California) and federal tax rates start at 10% and can go as high as 37%. Unfortunately, the investment gain portion of your 401k won’t get separated out and treated as a long-term capital gain, which it would if your investments weren’t held within a 401k and were owned for at least 12 months. Long-term capital gain tax rates only range from 0 to 20%.
Also, I think it’d be a rare person whose income tax rate would be lower in retirement than in their 20’s when they most likely had minimal work skills and experience. (If that’s the case, you’ll likely have much bigger financial problems than whether or not you’ve properly managed your 401k account.)
Then, of course, we have no idea what the tax rates will be in the future and they certainly could be raised. This has happened before. For example, the highest U.S. income tax rate jumped from 15% in 1916 to 67% in 1917 to 77% in 1918. You know, war is expensive.
In the 1950s, 1960s, and 1970s (30 years), the top federal income tax rate remained high, never dipping below 70%. If you’re not concerned about the potential for rising income tax rates, I’d recommend that you review this History of Federal Income Tax Rates. It will frighten you.
Finally, the 401k only allows for small tax savings up front when you are young or middle-aged, but this is when you’re most likely to have the best tax write-offs relative to your income.
During these years, you’ll be most likely to have write-offs based on potential factors such as dependents, student loan interest, work-related education expenses, mileage, business expenses, home office, etc.
Cutting straight to the point: We don’t know if you will save money on taxes or not. What we do know is that you’ll have your money taken away from you for 30 to 40 years to incur hefty fees (see below) and be managed by people you’ll never meet.
8. Hefty and Hidden Fees
With a 401(k), you’ll also pay hefty fees to the folks on WallStreet as they get 1-3% in fees from you every single year.
These fees can fall into three categories, including:
- Investment Fees
- Administrative Fees
- Individual service fees
Furthermore, the amount you are paying in fees are almost never clearly disclosed, so you’ll have to dig through the small print with a fine-toothed comb, reading mutual fund prospectuses and annual reports, cover the cost of managing the investments.
According to a survey from TD Ameritrade:
- 37% of people don’t believe they pay any 401(k) fees
- 22% didn’t know about fees
- 14% don’t understand how to determine what fees they pay
As described by the “Father of the 401(k),” Ted Benna, the 401k “helped open the door for Wall Street to make even more money than they were already making.”
9. 401k’s Can Plummet in Value
To make matters worse, 401(k)’s can potentially decline in value right at the time you need them (retirement). Unfortunately, this has happened very recently in history.
For example, Target-Date Funds whose investors were on the verge of retirement experienced losses exceeding 20% in 2008.
Target-Date Funds with retirement dates beyond 2020 experienced losses worse than 30%.
Of course, it’s also happening now with the Coronavirus-induced plunge. Stock exchanges have been in a free-fall since mid-February and there’s no end in sight.
10. 401k’s are Tied to Your Employer
Another downside of 401(k)s is that they’re tied to a specific employer. As a result, when you switch jobs, your 401(k) money won’t switch with you.
Most people today don’t stay with the same job for their whole life anymore. The 401(k) was a natural fit for that type of company and worker.
It’s a real headache and a hassle to have to roll-over 401(k)s when you move to a new employer. When you leave your current job, you’re limited to the following four options:
- Leave your 401(k) at your old job (not always possible).
- Transfer it into your new employer’s plan (not always possible).
- Roll over your 401(k) into an IRA.
- Cash out your 401(k) by paying a 10% penalty, plus your taxes owed.
Plus, if you do want your employer to write a check to you, they’ll be obligated to withhold one-fifth of your money (20%) in taxes.
Unsurprisingly, job changes are one of the key reasons that American 401(k) plans now contain billions in unclaimed and forgotten money.
11. You Give Up Control
Another reason that I dislike the 401(k) is that it requires you to give up control of your money.
You place it into the hands of fund managers on Wall Street and you “trust” them to handle it for you.
Seeing as you’ll never meet these people and they are compensated for collecting fees from you, do you really trust them to put your financial interests first?
Truthfully, you probably didn’t care about this until a few weeks ago when the Coronavirus hit. Now, with the markets in free fall, odds are you care a lot.
Ask yourself, how certain are you that you 401k manager will do their best work to manage your assets and give you unbiased advice (not tied to their own commissions) throughout your lifespan?
12. The Wealthy Don’t Use Them
If you were stuck in an elevator with a wealthy person and got to ask them how they amassed their fortune, I guarantee they won’t say it came from placing a small fraction of their paycheck into a 401k, allowing someone else to manage it, and waiting until retirement to touch it.
Wealthy people take a different path, which is to invest in income-producing investments throughout their lifespan. As financial guru Grant Cardone explains, wealth is acquired by increasing your income, investing in income-
Put simply, wealthy people rely on three strategies (of which moving money into a 401k is not one of them). These are:
- Consistently increasing skills, in order to increase income. Money is produced from scarce, in-demand resources, so make yourself a scare, in-demand resource.
- Regularly moving cash into income-producing investments.
- Knowing business and tax laws, because it’s important to reduce your tax liability while staying compliant with the IRS Tax Code.
As Tony Robbins wisely says, “Success leaves clues.” By this he means, you should model the people you want to be like. If you’re aspiring to be financially free, then you would do well to observe how wealthy people act and use a similar approach to achieve financial freedom yourself.
Is a 401k Worth It?
As you’ve now learned, 401(k)’s are one of the worst tools for wealth-building.
At best, a 401k will provide you with a moderate retirement nest egg when you finally reach 59.5 years old. As the term “nest egg” suggests, this approach is fragile.
Wall Street’s obsession with pushing the 401(k) onto hundreds of millions of Americans reminds me of how marketing campaigns in the 1970s and 1980s pushed that cheap, sugar-packed, carb-dense cereals were a healthy breakfast food.
Thousands of health studies have now confirmed that sugary cereals are not only a poor breakfast choice, but are detrimental to your long-term health and a key factor that has contributed to the alarming rise in childhood obesity.
Similarly, there are now 55 million workers contributing to 401k plans, which hold more than $5 trillion in assets. That is $5,000,000,000,000 with TWELVE zeros.
If our 401(k) system was working for these hard-working people, then why are the vast majority of Americans still scraping to get by?
If we have this great retirement tool called the 401(k) plan, then why do 40% of Americans not have $400 in the bank for emergency expenses? Should it concern us that 60% of Americans would be unable to pay for an unexpected expense of $1,000?
These are the hard questions that we should be asking.
Is a 401(k) a Good Idea?
Put simply, no. The 401k is a terrible investment vehicle for most Americans.
As I frequently say, “401(k)s make a lot of sense if you don’t think about it and little sense if you do.”
In contrast to the 401(k), there are plenty of smart financial options that will produce income for you throughout your lifespan.
Examples of income-producing investments include rental real estate, peer-to-peer lending, real estate funds, income-producing businesses, mortgage tax liens, corporate and municipal bonds, and dividend paying stocks, funds and ETFs held outside a 401(k), to name a few.
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*Disclaimer: I’m not a financial planner and nothing in this article should be construed as financial advice. Before making any decisions, you should consult with a professional adviser, such as a financial planner or CPA.