The Myth: You should always max out your 401(k) contributions.
Ever since I graduated college many years ago, financial services firms have been touting the glories of the 401(k). The concept is simple: you agree that every time you get paid you will have money taken out of your paycheck and deposited in a special retirement account.
That money, which will not be taxed until you withdraw it from your account years from now, is used by the financial firm to invest in the stock market, which historically has always gone up. As an additional bonus, your company might also match your contributions to your account, which adds to your eventual wealth.
The theory is that, decades from now when you’re ready to retire, you’ll have millions of dollars in the bank to use to finance a comfortable life. Promotional materials have lots of glossy graphs that show how a mere $20 saved every week starting today will turn into $2.75 million by 2065 (or some other similar compounding scenario). It’s wealth creation without effort or thought! It’s a no brainer!
- The 401(k) path to wealth assumes several things: 1. You will always have a job that offers a 401(k) plan, 2. You will consistently make the same or more money than you are making now over the course of 40 years with no interruptions, and 3. The value of the stock market in general and your investments in particular will always and consistently go up. None of these assumptions are valid. During rough patches, such as the Great Recession of the 2000’s, one of the first things companies do is cancel 401(k) plans and/or matching contributions. You’ll have to cross your fingers and hope you don’t want to retire in the middle of a recession.
- When you open a 401(k) or retirement account, you are giving a financial company a long-term, interest-free loan they can use play the stock market and make money for themselves. And from their perspective, it doesn’t matter if the market goes up, down, or sideways! It’s not their money they’re risking. And they’ll always get their management fee no matter how much value your portfolio loses or how little it gains. They enjoy the benefits of playing the market while you assume the risk.
- In the 40-50 years between the time you graduate from college and the time you retire, you are going to need money. And not paper wealth – you will need CASH. And to get your cash out of a 401(k) plan, you will be charged an early withdrawal penalty. What other industry gets to charge you so much to access your own money?
- And what about those precious tax benefits? Even if you aren’t paying taxes on your 401(k) money now, you will be paying taxes on that money at some point, whether it’s in the near future when you take money out before retirement, or when you do retire, or when you die and whoever inherits your money takes it out of the bank. Tax rates may be lower 30 years in the future, or they may be higher. There’s no way to tell.
- There’s also an opportunity cost to using a 401(k) plan, by which you are locking up a portion of your cash for decades. That’s cash that could be used for a lot of other things during your life. Things you might end up paying for with credit cards that accumulate interest. You might get a kick out of staring at your balance statement every month, but remember that there’s a reason your mortgage company, your auto loan holder, and your college loan companies all insist on getting paid in cash each month and not in IOUs or stocks.
If you don’t know how to save, by all means use the 401(k) to protect yourself from your own lack of knowledge. But if you have large long-term debts (credit cards, school loans, car payments, a mortgage, etc.) you should give serious thought to using the cash from your paycheck to pay those off first instead of locking it up in a retirement fund. You might decide that the benefits of saving money now by not having interest pile up year to year outweigh the imaginary pot of gold that might be yours 30 years from now.
If you have a basic level of responsibility about money, you’re better off investing your money yourself into stocks, mutual funds, or other investments. ETFs like index funds that track the performance of large sectors of a market are a great way to put money into the stock market without having to worry about the fates of individual companies. The advantage is in the liquidity of your assets, and that you can get them back when you want to without a penalty.
Yes, investing in the stock market is gambling. Ben Franklin had great advice about this, though: put no more than 10% of your total portfolio into “speculative” investments, which I consider to be stocks, mutual funds, commodities, or other items you can buy or sell on an exchange. If you follow this rule, you can be part of the market while still being able to sleep at night. You might even make a little bit of money...but don't expect a pot of gold.