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401(k) Sucks - Why?



You might have heard of the story of a worker frog placed in slowly warming water would eventually die. This metaphor is quite appropriate when applied to 401(k). Here is why?


401(k) was created in 1980 using the laws that existed then, tax rates that were applicable then, and for then-prevailing interest rates. Let us compare tax structure of the 1980s with today's tax structure and see how the incentive structure changed over time.

  1. The marginal federal income tax was 43% in 1980, today it is 12%

  2. The capital gains tax rate was 28% in 1980, today it is 0%

  3. The likely retirement tax bracket was 15% in 1980, today it is 12 %

  4. Interest rates in 1980 were around 15%, today it is 0%

So if you had 401(k) in 1980 with 30 years to retirement, the 401(k) tax deferral would have contributed an additional investment return of 9.2% per year, and an extraordinary incentive to save for your retirement. Using today's number the benefit comes out to 0.6% considerably less than the 1% to 2% in fees investors pay in typical 401(k) plans.


The above example compares paying ordinary income tax returns yearly. But investors also have option of using tax-efficient investment taxed mainly at capital gains rate at the time of withdrawal. In the 1980 environment, the 401(k) plan had a 2.5% annual advantage over tax-efficient investments in a taxable account. In 2020, there is no tax advantage to stay in 401(k).


So in 1980, the government offered huge tax savings to encourage retirement savings, while it offers little or no benefit today. The employer contribution is still valuable, with 100% match worth 2.3% per year extra return over 30 years, but it has nothing to do with the 401(k) structure.


Another big change since 1980 is the availability of low-cost, tax-efficient, well-diversified index funds in the convenient form for retail investors. Yes, 401(k) plans have reduced costs as well, but to a much smaller degree. In 1980, a typical investor would have paid 3.5% of assets in fees either in and out of 401(k). In 2020, that shrunk to perhaps 1.5% in a typical 401(k) and 0.5 outside.


Now that 401(k) has become the primary source of retirement savings for the middle class working in the private sector, every family has to rethink for themselves and ask - "Is 401(k) still the best vehicle for my retirement saving?". The current tax structure does not offer any incentive for us to save money in 401(k)!


Well actually the worker frog may jump out of the water but the metaphor is quite appropriate for this context. So why should we dump all our money into an in-efficient vehicle? Think for yourself! Why not jump out to a far better efficient system that would add better returns to your portfolio?

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