Monday, January 21, 2013

The 401(K) Trap

The 401(K) Trap

Every year $70 billion is withdrawn from 401(K)s and other defined contribution plans for non-retirement reasons, according to a very useful study published by HelloWallet[1].  As the paper shows, this is a significant figure.  For every $1 that employees and employers commit toward retirement, 24% is being withdrawn to pay bills, deal with debt, and address emergencies.[2]  As you might imagine, folks making less than $50,000 annually are very likely to withdraw (35%), borrow (13%), or cash out (30%) from their account. 

Obviously, these breaches represent a setback for retirement planning.  However, the setback is less than meets the eye, because 401(K) balances are only 7% of the assets of people approaching retirement.[3]  The real problem is that wage stagnation has turned the 401(K) into a rainy day fund for an ever-increasing numbers of families because they don’t have any other liquid assets to address exigencies. 

Preparing to Market funds (1999)

The 401(K) is a horrendous way to meet emergencies.  First, participants have to pay money managers and administrators while their money is invested.  These fees are extremely expensive if your 401(K) is really a rainy day fund.  Second, equities aren’t an appropriate way to protect principal if you’re going to have to meet a sudden financial need.  And third, withdrawals and cash outs trigger a 10% tax penalty, plus normal taxes.  For example, if you prematurely withdraw $10,000 from your 401(K), you’ll only net somewhere between $5,000 and $7,500 to meet your financial problem.[4]

Unfortunately, a lot of low-income workers are attracted to 401(K) plans without understanding the consequences if they need the money before they reach age 55.  They are encouraged by their company and the plan administrator to invest in equities for long-term capital appreciation, which would be appropriate if they were truly investing for retirement.  Frankly, they would be far better off putting the money in a low-cost bank account.

Professor Richard Thaler, a behavioral economist, has argued that employees should have to opt-out of 401(K)s rather than having to opt-in.  He believes that this change would get more people to save for their retirement.  In theory, Professor Thaler is correct.  However, the average American has more immediate problems than retirement and can ill afford to have his money trapped in a 401(K).

Saving for retirement is a laudable goal, and it’s easy for someone in the 99th percentile (income of about $350,000) to argue that we all should be putting money into a 401(K).  However, the median income is $49,000, and it’s only grown by 11% in the last 20 years.[5]  It’s no wonder that those median households don’t have much money set aside and wind up invading their 401(K)s to pay the bills.  Meanwhile, the top 1% has seen their incomes rise 63%, and the top 0.1% have enjoyed a 115% increase in the last two decades.  Obviously, these folks can afford to sock away part of their salary in a 401(K).  They really don’t need a government tax subsidy to help them build a retirement nest egg.

If our government had more sensible policies, we would create tax incentives for the working poor and median income families to help create a proper rainy day fund, and we’d offer them traditional defined benefit plans for their retirement.  At the same time, we’d eliminate the tax benefits for the wealthy.  Don’t worry; it isn’t going to happen.  The money managers are making way too much money from tax advantaged investing for the well-to-do, and the well-to-do finance our political system.

[1] “The Retirement Breach in Defined Contribution Plans: Size, Causes, and Solutions, January 2013”, Matt Fellowes, Founder & CEO of HelloWallet ,Katy Willemin, Data Analyst at HelloWallet,
[2] Employees put $176 billion, and employers add another $118 billion into 401(K)s annually.  Ibid, pg. 2.
[3] Ibid, pg. 8.
[4] The net amount varies depending on the taxpayer’s federal and state tax rate.

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