There has been a lot of talk about maximizing your 401(k) before you
do anything else financially. Some well known financial ?experts? are
wrongly advising clients that this is the first and most imprtant
decision to make. I strongly disagree with this analogy. If you look at
it from a economic point of view, the problems become more visible. The
401(k) was never intended to be the primary source of retirement
vehicle that it has become. Before I discuss the problems, lets
establish a scenario that I think is pretty typical.
Let?s
assume a 35 year old man begins to contribute to his 401(k) in the
amount of $6000 per year ($500 per month) before doing any more
planning. The company matches the contributions 100%. He assumes his
long term rate of return is going to be 8%. Here are some of the
problems with the 401(k):
If he becomes disables, the
contributions to the plan stop. If he is disabled for any length of
time, it will have a tremendous impact of his future plan. If there are
medical bills associated, it could put an impact on the amount of money
that he may be able to contribute in the future because of medical
bills. Many people do not understand the contributions will stop if
they are disabled.
If he dies before retirement, the family
would only receive the money in the 401(k) at that point in time, not
the money he would have had at retirement. It is not a self completing
plan.
If he does live to retirement, he would expect to have
$1,468,000 ($12,000 per year @ 8$ for 30 years) and this would likely
put him in the highest tax bracket. While we do not know the future of
taxes, it is safe to say they are not going away. Assuming today?s
calculations, he would owe $513,000 in federal taxes. If you ad the
state tax in on top of that, the number gets even larger.
Assuming
that he only has to pay the federal tax, what is his spending power
going to be in the future? If we only assume a 3% inflation rate his
money would have a purchasing power of only $393,000 in today?s
dollars. On top of that, he needs to be careful of any estate tax that
may be applied at death.
There is also a lot of concern about
the government changing the rules. We never can predict the next year
or so, let alone 30 years from now. How can we be sure that the
government is not going to change some of the rules between now and
then?
These are just a few of the problems with the 401(k). Please
understand that I do not recommend that you discontinue contributions
to your 401(k) by any means. I believe that there is a time and a place
for the use of them, but they must be understood from an economic point
of view. I myself contribute to 401(k)?s, but you must understand how
it effects you in all aspects of life.
While I do
suggest that you participate in your 401(k) plan, if available, it may
not be the first financial commitment that you make. Please seek the
advice of qualified professionals. If you need to know of one in your
area, let me know and I may be able to refer one to you. In the mean
time, check back soon as I will pose some possible solutions to the
401(k) problem. We all need to understand the rules of the game if we
want to make it through retirement, let alone have a prosperous one.
If you want to read a good book, check out The Great 401(k) Hoax
