It’s hard to find something everybody agrees on.
Crunchy or smooth?
Smooth.
Mac or PC?
Fries or onion rings?
Fries. But if there’s one financial instrument that seems universally beloved, it’s got
to be the 401(k).
Everybody loves ‘em!
People delay saving for a home, building an emergency fund, or even paying off high-interest
debt in pursuit of this conquering hero: the tall, dark, and handsome 401(k).
My hero…
There’s a whole lot to love with the 401(k).
So saddle up and take a ride to find out what makes this cowboy the darling of investors
everywhere!
The year was 1980, and The Revenue Act of 1978 was finally going into effect.
And deep in the bill was a tiny provision; Section 401, Subsection K. Largely overlooked,
Section 401(k) allowed employees to defer taxes on bonuses and stock options -- basically
a way for rich executives to make more and pay less tax on it.
But everything changed in 1981 when the IRS ruled that employees could also contribute
from their SALARY.
This was music to employer’s ears!
Managing all those employee pensions was expensive, complicated, and downright risky!
Maybe this new fella, 401(k), could replace the dusty old pensions of our grandpappies.
Before long, 401(k) fever was spreading like wildfire!
By 1996, 401(k) accounts held over a trillion dollars!
How does it work?
Fundamentally, a 401(k) is an employer-sponsored investment account.
It lets you invest part of your paycheck and receive a tax benefit for doing so.
Like company-provided insurance programs, you have to opt-in to participate.
The most attractive feature is the “employer match”.
Translation: if you save for your future, the boss rewards you with “free” money,
matching your contribution dollar for dollar, up to a limit.
Around half of 401(k)s offer an employer match and this “free money” can come to
thousands of extra dollars!
Then there’s the sweet tax breaks.
Depending on the type of 401(k), your contributions could be “pre-tax”, meaning it lowers
your taxable income for the year.
OR, you can pay the tax now, and allow that money to grow tax-free.
The more you save, the less taxes you pay.
Looking pretty spiffy over there, Mr. 401(k)!
Oh -- and don’t forget that your contributions are being invested in stock and bond funds.
We have Two Cents episodes about those if you’re not sure how they work.
Now you can just sit back and watch compound interest fatten your herd!
Free money, big tax breaks, and investment growth!
What’s not to love?!
Hold your horses there, partner.
While the 401(k) has a lot going for it, there are a couple burrs under the saddle.
Like the risks of managing your own investment portfolios instead of leaving it to the professionals.
As 401(k)s soared in popularity during the 80’s and 90’s, billions of dollars flowed
into risky sectors like tech-stocks.
And when things came crashing down -- like they did twice in the 2000’s -- many working
folks were left adrift like a tumbleweed in the wind.
And did you know that “Mr 401(k)” doesn’t work for free?
A study by TD Ameritrade found that 73% of participants didn’t know how much their
401(k) costs, while 37% weren’t aware they were paying fees at all!
Investment firms regularly rack up hefty fees since nobody’s paying attention -- with
the average being around 1.4%!
And remember that juicy employer “match” we mentioned earlier?
Well, that might not end up being yours thanks to “401(k) vesting”.
Even though funds might appear in your account, they’re only yours once you become “vested”
-- often 3 to 5 years after you get hired!
With the vast majority of millennials only expecting to stay in a job for a few years
at the most, that’s a lot of “free money” that never gets collected.
Despite their perks, and general popularity, 401(k)s have left a societal legacy that’s,
well, ugly.
See, 401(k)s were originally designed to be a supplement to worker pensions.
For most of the 20th century, it was common for workers to stay with a single employer
for most of their lives.
And for that loyalty, their company offered a defined benefit pension for the worker’s golden years.
These plans offered steadiness and security, with the employer watching over everyone’s
plans -- from the janitor to the CEO.
By their peak in 1980, 38% of all private sector workers had an employer pension.
Today, thanks to the 401(k), only 13% of private sector workers have a pension.
And while 401(k)s have their perks, they're just not as stable or reliable.
401(k)s are also “opt-in,” which means you aren’t automatically enrolled.
Left to their own devices, many employees simply aren’t saving enough -- if they’re
saving at all.
Of the 79% of workers eligible to save into a 401(k), only 41% opt to participate.
The National Institute on Retirement Security finds that the median retirement savings balance
is just $3,000 for all working-age households and a mere $12,000 for those near-retirement!
Most financial experts recommend a personal retirement savings rate between 10 - 15%.
The real rates are between 1 and 3%.
The 401(k) was designed to be the side-dish, not the main course.
Saddling workers with the “opportunity” to manage their own retirements has created
a national crisis in retirement preparedness.
But the good news is that if you know its place, and use it wisely, a 401(k) can be
a great part of your financial toolkit.
Since pensions are going the way of the horse and buggy, you’ll need your 401(k) to be
galloping double-time to keep from being left in the dust.
Take advantage of it and you’ll be riding into the sunset instead of off a cliff.
And that’s our two cents!
If you've been transitioned from a pension to a 401(k)
tell us about experience in the comments!