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5 Reasons to Throw Away Your 401K

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I've been doing a lot of thinking about 401K's lately. Almost every financial professional screams from the top of his/her lungs that it's a great deal. If your company offers matching funds it's probably a great idea to take advantage of that. If you are like me and your company doesn't offer a 401K match, should you still contribute? I used to think yes. Now that I've done some math, I'm not sure. Let's look at some of the reasons why I wouldn't want to contribute to my 401K:

  1. Today's tax rates are relatively low in the large scheme of things (see this website for evidence). With a 401K you are basically deferring paying today's low tax rates for whatever the future's tax rates are. I don't have a crystal ball, but if taxes are low now and we have health care and social security problems in the future, I would suspect they'd be on the rise.
  2. With 401Ks, you can face a penalty if you need to get your money early. Sure you can take a loan, but if you want to leave your job, you have pay that back immediately or pay a penalty on the money. If I invest the after tax money myself and I need it for whatever reason, I can sell the investment at no penalty.
  3. With 401Ks, you are limited in where you can invest your money. Often times your choices have high administrative fees and expense ratios. Free Money Finance says that the average large cap equity fund has an expense ratio of 1.28% while some exchange traded funds are typically under 0.15%.
  4. When you withdraw money from your 401K plan, it is taxed at ordinary income, currently 25% for many people. If you invest the money after taxes, you can take advantage of long-term capital gains and dividends rates, currently 15%. Again, I have no crystal ball to know what things will be like in 30 years, but if we use today's rates as a guideline, I'd rather pay 15% over the 25%.
  5. The Math:
      401k Regular Account
    Starting $15,000 $15,000
    After Starting Tax $15,000 $11,250
    Growth Rate 9% 10%
    Year 1 $16,350 $12,375
    Year 2 $17,822 $13,613
    Year 3 $19,425 $14,974
    Year 4 $21,174 $16,471
    Year 5 $23,079 $18,118
    Year 6 $25,157 $19,930
    Year 7 $27,421 $21,923
    Year 8 $29,888 $24,115
    Year 9 $32,578 $26,527
    Year 10 $35,510 $29,180
    Year 11 $38,706 $32,098
    Year 12 $42,190 $35,307
    Year 13 $45,987 $38,838
    Year 14 $50,126 $42,722
    Year 15 $54,637 $46,994
    Year 16 $59,555 $51,693
    Year 17 $64,915 $56,863
    Year 18 $70,757 $62,549
    Year 19 $77,125 $68,804
    Year 20 $84,066 $75,684
    Year 21 $91,632 $83,253
    Year 22 $99,879 $91,578
    Year 23 $108,868 $100,736
    Year 24 $118,666 $110,809
    Year 25 $129,346 $121,890
    Year 26 $140,987 $134,079
    Year 27 $153,676 $147,487
    Year 28 $167,507 $162,236
    Year 29 $182,583 $178,460
    Year 30 $199,015 $196,306
    Tax Rate 25% 15%
    After Tax $149,261.38 $166,859.91

    Here I took $15,000 and showed how it might grow over 30 years in a 401K vs. a regular after tax account. With the 401K, I don't take taxes out until in the end. I assume it grows at 9% due to extra fees and adminstrative expenses. With the after-tax account, I immediately take 25% off (to pay taxes) and assume 10% growth (an extra percent that can be saved by going to low-expense funds). At the end, I take the 15% off for long-term capital gains tax.

So is it possible that the after-tax route is really better than a 401K? It appears to me that it very well could be. I may be missing some of the minor details or my math may be off.  If that's the case, please help me fill in the gaps in the comments.

Update: As I was getting ready to post this, I happened across a similar article at My Pocket Change. It goes into a lot more details about the advantages and disadvantages of a Traditional IRA vs. a regular account. It's definitely worth checking out.

Posted on February 14, 2007.

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41 Responses to “5 Reasons to Throw Away Your 401K”

  1. I share your sentiments. At my old employer I had access to a Roth 401k which to me is better than a standard account, but now I’m forced into a traditional account and outside of the company match I am seriously considering diverting the extra money into a standard account for many of the reasons that you listed above.

    It’s all about freedom. Freedom on what to invest in, when to withdraw it, and in the end if you are right about taxes you could potentially end up with more money. To me I feel safer paying a known tax now than an unknown tax in the future.

    There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know. See Don Rumsfeld was actually talking about tax brackets and not the war in Iraq. It makes perfect sense now ;-)

  2. #1: A tax break right now is far better in my book than the hope of lower taxes 30 years from now. If, for example, we end up with a consumption tax, you’ll pay taxes twice without the 401(k) (then again, maybe they’ll go back and grab their share from the deferred contributions).

    #3: Use index funds. At Vanguard, there is a vanishingly small difference between the expense ratio of a domestic index fund and the equivalent ETF. And you don’t have to pay a broker to buy an index fund. Also, it’s pretty clear that you’re assuming equity investments here. If a portion of your investments are bond funds, holding those outside a tax sheltered account will kill you.

    #5: See #3. Use index funds. It’s easy to show that one scenario outperforms another if you arbitrarily give it a higher rate of return. But that’s simply not going to be the case if you’re smart (unless you have a really, really bad 401(k), but that’s another issue entirely).

  3. Chris Hynes says:

    #5: Another thing to consider here is the 401(k) match. I have a 4% match here, and have seen 6%-10% at other companies. Some even deposit a lump sum yearly as a bonus. Since your math is based on an initial deposit, this wouldn’t add up as much as continuous payments, but it’d still give the 401(k) another advantage.

    This actually brings up an interesting point. What would the difference in result be if you were continually paying into both accounts? Most people don’t just stick in a lump sum and leave it. It seems to me that taking that 25-28% hit constantly may also decrease the attractiveness of a normal account vs. a 401(k).

  4. Angy Dinosaur says:

    Maybe the 401k will do better, or maybe the regular account will do better. It is difficult to predict. The lesson here is a familiar one in investing: Don’t put all your eggs in one basket. Diversify your savings by using both a regular account and a 401k, and then you can mitigate potential risks.

  5. Lazy Man says:

    Thanks for the discussion Nickel. Some responses:

    #1. While I’m hoping for lower taxes 30 years from now, I think they’ll be higher and return more to the historical averages. I’m more afraid of paying higher tax on income in the future.

    #3. Yes, index funds are also an option, especially those at Vanguard. Commissions aren’t mandatory nowadays with Zecco in the world. I hear that Bank of America allows some commission-free trading under some circumstances. I stay away from bonds for now as I have a high risk-tolerance and lots of time, but I could see including some bond funds in a Roth IRA. That way you’d get to choose your bond fund for low expenses. I realize you’d be limited to $4000 a year in there, but that would be enough to diversify many people’s portfolios.

    #5) I’m not sure it’s that arbitrary. There are a fair amount of administrative costs that are built into 401Ks (these companies that run them have to take something), though I’m not sure where they get taken out in the process. The two index funds in my 401k have expense ratios of 0.63 (S&P) and 0.95 (small cap), which are still fairly high compared to the Vanguard equivalent. If I want to have some emerging markets exposure it jumps to 2.14%. Perhaps the answer is to manage your expenses well within your 401k. I’d still like to know what the companies are making to run these plans though.

  6. Angry Dinosaur says:

    Chris,

    Continuously paying into the account is equivalent to making a series of single, lump-sum payments. So the difference in performance for a series will be the same as the difference in performance for a single lump sum.

  7. MossySF says:

    The key is to not view your 401K in isolation with the rest of your investment portfolio. If all you have is a 401K, then yes you should be diversified across all the major categories which means buying whatever the plan offers (which is usually pretty bad outside the large cap area). But if you also have your own IRA, Roth IRA, taxable accounts — pick the 1 or 2 top choices available and use your other accounts to fill in around it.

  8. Lazy Man says:

    Chris, I’m focusing on situations where 401k’s don’t have matching funds. As I said in the opening, if your 401k offers that, it’s probably a great idea to get that free money.

    MossySF, in some ways, I like to look at 401k in isolation. I made the comment of putting bonds in a Roth IRA. However, it can get complex as you have to take taxes into account figure out how diversified you are.

  9. Sun says:

    Your calculation didn’t consider the fact that all distributions are taxed annually in regular after tax account. If all the distributions are reinvested, there will be a big difference between tax deferred account and regular account, though I don’t have the exact number right now. Plus, benefits of 401K isn’t just get a tax deferred growth which you enjoy in the future, but also the current benefit of lowing your taxable income. For a fair comparison, that should be considered as well.

  10. MossySF says:

    BTW, your math for regular accounts is too simplistic. In the regular account column, you have to reduce the yearly returns by the distribution amounts. What you need to do is apply tax to the distribution (dividends cg turnover) yield every year and then apply the 15% tax to the difference. Let’s used Vanguard funds as our baseline for absolute optimal tax results. My Vanguard funds had the following dividend distributions last year (absolutely no turnover).

    Large Growth: 0.75%
    Large Value: 2.5%
    Small Growth: 0.5%
    Small Value: 4.0%
    International: 3.5%
    REIT: 8%
    Bonds: 5%

    Bonds and REITS taxed at full income rate. 2/3rds of international taxed at 15% – 1/3rd not considered qualified dividends (not all foreign countries/industries/corps meet the qualified dividend standards). Assuming a quick and dirty allocation of 1/7th per category, total tax on distributions are:

    0.75 * 1/7 * 15% = .0161
    2.5 * 1/7 * 15% = .0535
    0.5 * 1/7 * 15% = .0107
    4.0 * 1/7 * 15% = .0857
    3.5 * 1/7 * (15%/66.66 25%/33.33) = .0917
    8.0 * 1/7 * 25% = .2857
    5.0 * 1/7 * 25% = .1786

    Add it up and you have a tax drag of 0.722%. This means you must reduce your 10% return each year by roughly 0.70%-0.75%. Since this is from dividend distributions, the numbers are pretty constant whether the market is up or down so you can use it for long term calculations. With this factor in play, that drops your regular taxable account at the 30 year mark is $151,341 after taking 17.5% tax on 4.126% of 10% returns every year and then applying 15% taxes on the remaining cap gains.

    This number is very close to the $149,261 amount leftover with crappy 401K invetsment options. If you tweak the return % for the 401K column, you’ll find the equalibrium point at 9.05% return. This means a 401K is the better option than a taxable account as long as the EXTRA fees charged is less than 0.95%. (E.g. Vanguard index fund at .20%, you can up to 1.15%.)

  11. Lazy Man says:

    Good points, Sun. I think the My Pocket Change addressed that and found that it can be a very small, nearly insignificant number. Since I’m assuming index funds with very low turnover I think this may be true. It’s still worth running the numbers though.

    I take advantage of that lowered taxable income today. There may be a time where that helps me get under the Roth IRA income limits. This is hard to quantify though. I’d say it’s balanced out by the 10% penalty for early withdrawal that 401k accounts have, vs. the relative liquidity of the after-tax account. I know they are entirely different, but there’s a plus to weight against the minus.

  12. dan j says:

    Keep in mind that the 15% tax rate is not set in stone either, it too can change on the whims of politicians.

  13. Miller says:

    Lazy, as you said, I did a very similar analysis with a few more bits and pieces in there. Most the comments have addressed these though (you have great, informed readers!). It is pretty crazy to actually see the details and realize “retirement” accounts can be *worse* (!).

    As Mossy alludes to, it really depends on what type of investment you are considering. In my post, I try to show (not that’s is perfect) that S&P500 index funds are better in taxable accounts, but (as Mossy said), high distribution funds (bonds, value, REITs, etc) are better in retirement accounts. In the end, the rules should boil down to the classic rules of putting the most “tax sensitive” funds in sheltered accounts.

    What’s crazy to me is that I was analyzing non-deductible IRAs, whereas you’re showing the same types of trends in *deductible* retirement acounts!!! Now I’m really going to have to crunch the numbers again!

    Last comment, if you like to move around your investments AT ALL (i.e., not just the index fund flavor investor), I find it very hard to believe regular accounts would EVER be better due to the big cap gains hits. So active investors, semi-active investors, and even insignificantly-active investors be warned!!! Think it out first… are you really willing to not move that money at all for ~40 years (I’m 26)??? That’s a long long time to have no flexibility…

  14. Foobarista says:

    One other thing: 401Ks lower your modified adjusted gross income. This can help as you make more money – especially after you get married – and want to fund Roth IRAs or do other things that are MAGI-limited. For the past three years, we were able to get under the “Roth MAGI limit” by fully funding 401Ks. We won’t be able to do this for the 2006 tax year, but it is a consideration.

    The best “number” consideration in your example is cap gains and dividends, which are taxed higher in a 401K (or T-IRA and other tax-deferred things). My guess is at some point we’ll abolish corporate taxes (like many other countries are doing) and make dividends ordinary income, which would make 401Ks more attractive.

    The best investment point you make is that many 401Ks, especially in small companies, have awful investment choices. I personally believe that the company-managed 401K should be replaced with an employee-managed one, especially for smaller companies that can’t afford good 401K plans.

  15. I’ve never been able to qualify for a roth IRA. However, even with my 401k, I’ve had serious matching done by employers. Given a historically high taxable income, it’s indeed helped me lower AGI. I’d rather take my chances with deferral now and grow my account this way without bothering with the taxes involved. I’m at the point when any tax benefit helps. I pay a lot of tax today and adding more to it is just too much for me to subscribe to. Laws can change either way in our “golden years” down the road but I’ll face the music then. I also agree 100% with Sun’s points on this.

  16. MossySF says:

    One other good reason for going with a poor 401k plan — you won’t be working forever at the same company so you will get the opportunity to rollover into an IRA. That can end up being a big lumpsum you can use to go put into high dividend/high turnover investments without all the hassle of paying and reporting taxes every year. In the beginning, the contributions are a far larger part of the growth so it’s not a big deal to take a little hit then. Money you don’t contribute to a 401K (for future rollover to an IRA) is money that will never be available again to put into a flexible tax-deferred plan.

  17. Lazy Man says:

    MossySF hit the biggest reason right there. I had mentioned it in a private e-mail to Miller. I’ve been with more than a few different companies and the ability to roll it over into my own investment choices makes it worthwhile.

    As for the turnover, I wouldn’t hold bonds or REITs in taxable accounts. While my math may be simplistic, I don’t see that as being a major issue. Along the same lines, I wouldn’t sign up for the emerging markets fund in my 401k at 2.14%.

  18. […] tossing out your IRA for several reasons. And what do you know, Lazy Man @ Lazy Man And Money has also given reasons to toss that 401K! What, could our retirement accounts be […]

  19. […] 5 Reasons to Throw Away Your 401K by Lazy Man @ Lazy Man and Money: An interesting numerical take on whether 401K is the only answer to retirement savings. Before you conclude anything from this article, you must read all the comments. On similar lines, read about what Jim @ Blueprint for Financial Prosperity has to say about Roth IRAs in his post Why Roth IRAs Are Bad. […]

  20. […] how to invest in a 401(k) plan.  On the other end, Lazy man stirs quite some debates when he says he may want to dump his 401(k) plan. I know I won’t, for the reasons of 1) getting tax-deferred growth of distributions and 2) […]

  21. […] as I mentioned earlier, there are other reasons for arguing against a 401K, particularly those touching on taxes. Let me tell you now that this won’t apply to our […]

  22. Star Money Articles for the Week of Feb. 19…

    Here are interesting posts and news this week from the MoneyBlogNetwork members and beyond: AllFinancialMatters wonders if anyone should use a credit counseling service. MightyBargainHunter got a great deal on wings. Five Cent Nickel details how to get…

  23. mbhunter says:

    I’m leery of tax-advantaged accounts, mainly for reason #1. I get up to 4% of my salary matched so that offsets the risk a little, but I don’t contribute beyond that.

    Another reason to be leery is that the rules governing the accounts can change. How about a 20% penalty for early withdrawal? No reason it can’t happen.

  24. Investment Guru says:

    I struggle with this all the time. I have the ability to consistently generate 25%-40% returns with my investments, and I sit there watching these fund managers get me a paltry 6%-10% and take huge fees for it. I really don’t want to leave my company just to roll over the 401K to an IRA. I wish there were some law that allowed sophisticated investors to manage their own 401K funds. It is very frustrating to watch my other accounts grow and 3x to 4x the rate of the large lump sum in my 401K and I can’t do anything to change it. I’ve even considered borrowing from my 401K to invest it, but even then I can only get out $50K and have to start paying it back right away. Does anyone know a a movement to force employers to allow people to choose their own investments in a 401K?

  25. Brian says:

    Here is another reason to forget about the 401K. I work for a Fortune 500 company off the bat. Not liking their current track record on their investments in the 401K optional funds I decided to take an early withdrawal (even with the 10% hit). They are trying to say I cannot touch my own money unless I retire or quit the company!

  26. […] next change you can make is to lower the proportion going to your 401(k). You might be asking yourself why a finance guy would be telling you to lower your contribution rate. […]

  27. […] Finance asks if 401Ks are a bad deal. This is a discussion of a CNN Money article that mirrors my 5 reasons to throw away your 401k article. The Money magazine article doesn’t seem to factor in freedom of investments. I still […]

  28. Stix says:

    Obviously a Traditional IRA and a lot of assumptions about loads and fees.

    You could easily invest in a ROTH IRA and for go the Tax problem. Also you can invest where you do not have those fees for maintaining and loads. especially at 15K initial – many firms offer 10K free servicing. As for the funds – buy stocks that pay dividends.

  29. […] by never asking for a raise, doing crappy work, and staying in the same job. You might as well throw away your 401k as well. Muttering about your red stapler can’t hurt […]

  30. Robert says:

    My reason for steering clear of 401ks is the ponzi scheme they get invested in, the US stock market. My employer’s investment options are a$$ and then some. I might as well invest in apples and leave them out in the sun and hope they are good to eat when I 75 (I am 33 now), which ain’t happening.

    The reality is most Gen X and Gen Y people that have been shoved into this ownership society scam by the republicans will be living a life of work and misery unless they hit a lottery or have some rich uncle they do not know about with a large inheritance.

    I have already accepted I will die at some job when I am in my 70s or 80s when I praying for some dignified death. Maybe I’ll save something in a CD so I can go part time and sleep in late a couple days a week.

    What will really happen is millions of Gen X and Y people are going to be wandering around broke and homeless in their 70s and I hope the government has some plan to take care of all those people (I’ll likely be there with them with age discrimination the way it is in the US). Only then will they see the failure of this ownership society ponzi scheme.

  31. NewSunSEO Inc says:

    I have to somewhat agree with what you are saying. With the economy the way it is now investing money by itself maybe the safest way to go about investing. Also I believe that you shouldn’t put all your eggs in one basket and still invest into your 401K for your own personal investing safety. This is a really nicely written blog and I look forward to reading more of your great work.

  32. Jason says:

    Looks good on paper. You’re missing one aspect though. You are not taking in to consideration that most people are not putting a (1) time, lump deposit into there account. Most people are contributing to there 401.k on a monthly or even weekly basis. Therefore, every deposit made after year (2) will not have enough time to overcome the initial tax burden. In addition, your senerio only works for people in a 15% tax bracket. Many americans are in the 28% tax bracket.

  33. Gargamel says:

    I concur. The 401k distorts the market and isn’t a good proposition. I would say put in the matching amount and become a disciplined saver/investor. The tax penalty for taking out your own money is criminal. Having retirement age around the time of the average death age is not coincidental. I know now the life expectancy is higher but they are already adjusting it to match. The whole system is one giant ponzi scheme.

  34. […] income. The life of a contractor is often one without a 401k. Despite my Devil's Advocate post of throw away your 401k, having the option for automatic savings is great when you are as Lazy as I am. Well I'm not going […]

  35. time to fly says:

    AVOID TAXES AND USE ONLY CASH!!!!!!!!

    It is simple. If you put your money into any retirement account under someone else’s control, you will lose it, or its value. Follow my logic. If you give a company money or invest, the amount of time you give those companies to hold your money is more time they can figure a way to cheat you and run off with your hard earned money. Never invest in American anything, they are crooks. Mankind is a bunch of crooks it is in our nature. Keep your money in a safe account of buy something like metals or valuables that appreciate over time.

    Next, we know Uncle Sam has cheated us all, and they do not deserve your tax money. All of us need to start using cash. Cash is untraceable and helps people not pay taxes. Now you may work for an employer and be forced to pay taxes and may think you should be against it, but … The quicker you can cause our crappy cheating U.S. government from functioning and ripping us off, the sooner we can get it back on track.

    When using cash or accruing it, make sure you take the cash out of the U.S. on trips and deposit it in a non-America based area like the Cayman Islands. Never put money or use credit that traces the money. You get cash in your business, simply pocket it and take it with you on your next trip. Alternately, you can buy precious metals where you don’t give your name and it may make it easier to transport. Forget all these 401K schemes and other investing boolsheet. They are distractions on how you can really save for your future. It takes less than one penny out of one dollar for everything we need from roads to infrastructure. Everything else is someone else’s agenda or waste.

  36. Tom says:

    1) A large majority of 401(k) plans have a match. You did say we are considering those without, so let’s move on.
    2) Why are you assuming a higher rate of return for the regular account? There are plenty of choices in a 401 (k), and even so, most index funds beat mutual funds and individual stock pickers.
    3) You have failed to account for the fact that any realized capital gains and dividends paid to your 401 (k) will be tax free. Every year.
    4) I guess tax rates could be raised sometime in the future, but not nearly high enough to offset the huge plus side on the front end which will accumulate at compound interest for 40 years, nor the dividends and capital gains that will not be taxed during that time (also accumulating in a compound manner).

    The only downside to the 401 (k) is the penalty for taking it out early. Plan accordingly. You really just show that you don’t understand compound interest, something which Einstein called the most powerful force in the universe. Please don’t spread any more uneducated drivel.

  37. Boris says:

    Where do you get those numbers – 9% average return, 11% return? My calculator shows me S&P has returned on average 0.35% a year for the past 13 years. Your bank loans you mortgage money at 3-4% a year, do you think they wouldn’t prefer 9-11% return, if it was for real? US Treasury sells bonds at 2% a year interest and there are HORDES of buyers, wouldn’t they know better and invest at 9-11%? Think about it.

    • Lazy Man says:

      Boris,

      The article was written in Feb of 2007. At that time research came out that it was a typical return over the course of many decades (50 years or more). Keep in mind that money invested in a 401k is done typically over a span longer than 13 years.

      Go try to get a private loan from a bank at 3-4%… they only loan the money at that rate, because they have the home as collateral. The Federal Reserve Bank is keeping rates low there now… even lower than it was in 2007.

      95% of people make between 6% and 18% at Lending Club. The hordes of people buying into 2% returns are doing it because they want the 100% guarantee and don’t trust Lending Club and P2P Lending.

  38. boris says:

    I wouldn’t say US bonds are 100% guaranteed at that point… You can paint 6% or 18% or any other nice number by carefully selecting the “start” and “end” points. That’s one of their favorite methods of defrauding simpletons.The other is to open multiple funds, then close those that returned -18%, and showroom those that returned +18%. If you look at the graphs, it shows that 200-years US stock market bonanza ended in 2000, and probably will never return.

    • Lazy Man says:

      Most people consider U.S. Treasury Bonds to be 100% guaranteed. If you do not, that is fine. You seem to be a student of history and history supports it being a 100% guarantee (at least to my knowledge).

      Lending Club does not carefully select “start” and “end” points and it wouldn’t matter if they did since the returns don’t differ on dates on P2P loans. It’s not like the P2P loan market can suddenly crash like a stock market. Also Lending Club can’t close funds that returned -18%, these are real people with real accounts. Maybe you aren’t familiar with Lending Club.

      Maybe the 200-year US stock market bonanza ended in 2000. I have made big point over the years in investing overseas. In my opinion, you don’t want to have too many eggs in one basket and that includes the United States.

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