401(k)s – COULD THEY BE MORE CONFUSING?
Which is more confusing on the first day of a new job, the company medical plan or the 401(k) plan?
I cast my vote for the 401(k). I understand finance and investing better than most, but I have to really concentrate in order to read the disclosures. Figuring out the investment options (confusing), guidelines (legalistic) and fees (expensive) takes forever and a lot of brain power.
I often get requests for advice on 401(k)s. Here is a summary of The Roadside Scholar’s 401(k) logic.
Do not think of a 401(k)s as a “retirement” plan. Think of it as an “income tax reduction” plan. Every dollar invested in a 401(k) reduces the individual’s tax bill today. This is effectively a loan from the government for the individual to invest with 0% INTEREST and NO REPAYMENT REQUIREMENT. Even taking into account a 10% penalty for early withdrawal (before 59 ½ years old) and paying taxes in the future, the deal is highly favorable to the individual. Participate as soon as possible.
A company match makes 401(k)s a guaranteed winner. Most companies match an employee’s contributions; the average match was 4.7% of base pay in 2019 according to Fidelity Investments. Using this average, if you contribute 4.7% of your pay and get a dollar-for-dollar match from your company, then your profit before any investment income is 100% the first year. You DOUBLE YOUR MONEY.
Unfortunately, more than a third of workers contribute below the match rate, “leaving money on the table,” said Angie Chen, assistant director of savings research at the Center for Retirement Research at Boston College. Take the free money.
The investment choices are confusing. Most 401(k) plans offer too many investment choices, tending to confuse the employee. The Roadside Scholar suggests selecting market bundles (index funds – large, mid-size or small company) in most cases. Doing so gives the individual the return of the market with low fees (see below).
Fees are high. 401(k) program fees are generally high. This is unavoidable. But, because of the tax savings and company match, the overall deal is still really good for the individual.
Rollover the money when possible into a self-directed IRA. An employee switching jobs can move the funds in the old employer’s 401(k) program to a self-directed IRA without paying taxes or early withdrawal fees. This is a great thing to do especially if the account is invested in market bundles: performance will be the same and overall fees will be lower. Do not cash out (sell the investments and take the cash out of a tax-advantaged account) unless funds are needed due to an immediate hardship.
Roadside Scholar Tip: 401(k)s are great for the individual investor. Take advantage.
For more information and easy to understand explanations of important money matters go to www.theroadsidescholar.com or purchase The Roadside Scholar: Amazing Money Lessons from Behind the Fence.