401(k)s: A good news, bad news story
By Peter “Coach Pete” D’Arruda
Capital Financial Advisory Group, LLC
"The trouble with retirement is that you never get a day off." — Abe Lemons
When President Jimmy Carter signed into law the United States Revenue Act of 1978, he probably had no idea that he was changing America’s retirement landscape forever. The legislation contained a little noticed (at the time) section 401, paragraph (k) that permitted American workers to save money for retirement and lower their taxes at the same time.
The new law was music to the ears of Ted Benna, a benefits consultant from Philadelphia, who seized upon the language of section 401, paragraph (k) right away. Benna was somewhat of a retirement plan visionary. The wording of the law allowed for bonuses, if saved for retirement, to be tax deferred. In other words, if you set the money aside and did not touch it until you retired, you would not pay taxes on the money until you retired.
It was Benna who saw that the new rule could also be applied to regular wages, allowing them to receive tax deferment if saved for retirement. Benna had, in fact, been working on a plan that would allow employers to match employee contributions and reap a corporate tax deduction in the process. He submitted the plan to the Internal Revenue Service, which officially approved it in the spring of 1981, giving birth to the 401(k) defined contribution plan. Despite its somewhat cryptic name, within a decade, the 401(k) would be on its way to eventually replacing defined benefit pension plans across the country.
There are many facets to the 401(k). One attractive characteristic of these types of savings/investment programs is that the money you put into it is tax deferred as it grows. In other words, you don't pay tax on the money until you take it out. Over time, compound savings, without any reduction for taxes, equals quite a financial advantage over savings and investment programs that are not tax deferred.
Many companies give participants a wide variety of investment options. These choices are designed to help you know your risk tolerance and invest accordingly. On one end of the spectrum will be growth funds, considered to be somewhat risky by many investors, while at the other end of the spectrum will be money market funds, considered the same as cash in the bank. If you make the right choices, then your investments do quite well, especially if you allow the principle of dollar cost averaging to work for you.
If you have a 401(k), it is important that you get the most out of it. If your employer offers matching funds, it usually means that the only way to get a contribution from the company is to make a contribution yourself. Some employers have generous matching programs, while others have meager ones. Some employers do not match at all. Two of the most common matching programs go as follows:
50 percent match up to the first 6 percent — This means that for every dollar you put into your retirement plan, your employer will place 50 cents into the plan. There is a limit of 6 percent of your gross salary per year that the employer will match. Someone with a $50,000 salary, for example, who contributes at least 6 percent to his/her 401(k) plan, will receive a matching contribution from the employer of $1,500. Dollar for dollar match up to 5 percent — This means that for every dollar you put in your 401(k) plan, the company will also put in a dollar. Once you reach a total of 5 percent of your gross pay contributed for the year, your employer won’t add any more dollars to your account until the next calendar year.
I would advise anyone to take advantage of a company match of any description. It’s free money, and that is always a good idea. Keep in mind that there are many variations on this theme. For example, your company’s contributions may be based on a vesting schedule. In other words, the money’s there, but you have to stay with the firm long enough — say 20 years or so — to get the full amount.
A lot of people I talk to in the financial industry have unpleasant things to say about the 401(k). Some call it the biggest rip-off in history. That may be a little harsh, but few dispute the charge that 401(k)s were set up for the purpose of advancing the cause of mutual funds, which is where most of the money from such programs is invested.
One negative aspect to 401(k)s is hidden fees. Fees associated with 401(k)s should be transparently disclosed on the statements provided to employees, but many times they are not. Many of these fees are referred to in the financial community as “inner fees” or “production fees.” They are sometimes difficult to parse out from the other information that appears on the statement. They sometimes take the form of “management fees,” which is another way of saying sales commissions. These are fees that you pay out of your paycheck, but likely didn’t knowingly agree to.
In most cases, employers contract with a fund manager to come into the workplace and enroll employees into the program. These folks are the ones who should — but often do not — provide full disclosure on these fees and commissions.
Another item on the list of 401(k) drawbacks is possible market loss. When untrained investors see their accounts lose money, they sometimes make investment decisions emotionally. They see the market ebb and flow and watch their money fall and surge with it. To some, this is maddening, especially when they are in the “red zone” — within 10 years of retirement. They either change their allocations based on fear, or attempt to time the market by moving in and out of mutual funds to their disadvantage.
In my opinion, the best way to manage a 401(k) where you are given decision-making power is to use a manager. Allow a trained professional to invest your money based on your age, your risk tolerance levels and according to what your goals are for the future. There should be more disclosure than there currently is when it comes to fees in 401(k) programs. And employees still have too few investment options.
But the most egregious flaw in 401(k) programs is the lack of a guaranteed lifetime income. Employees should know exactly, to the penny, what they can expect to receive in the way of income when they retire. What good is it to save all your life, only to retire with a lump sum that may not last throughout your lifetime?
I applaud those financial planners who recommend tax-free rollovers that, upon retirement, move the money from the 401(k) into an account that better fits what retirement is all about. If set up properly, this account can not only continue providing growth for the assets within the fund, but also provide a guaranteed income that cannot be outlived, in contract form. Many of these contracts can be structured to care for both the one retiree and his or her spouse. Sound familiar? Sound like the defined benefit pension plans of old? Yes, it does. But it could be done within the framework of the current 401(k) programs, and it would be a win-win for all concerned.
A few companies now are allowing employees to contribute to a Roth 401(k). That provision was approved by congress in 2006. If the company offers this type of plan, employees have the option of amending their plan document to elect Roth-type tax treatment. They can do this for either a portion, or for all of their retirement plan contributions.
Under the Roth 401(k), employees can decide to contribute funds on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401(k) plans.Employers are permitted to make matching contributions on employees' designated Roth contributions.
In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre-tax dollars are those that do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least five years after the first Roth contribution and the attainment of age 59 1/2, unless an exception applies.
A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket upon reaching retirement age. Also, higher-income workers who wish to save the maximum amount allowed may favor the Roth 401(k) because it effectively allows greater real contributions, as post-tax dollars are more valuable than pre-tax dollars. Tax the seed or tax the harvest?
To understand the advantages of a Roth 401(k) over the traditional 401(k), imagine that you are a farmer and it’s planting time. You are standing there with your bag of seed, ready to sow your crop, when along comes Mr. Taxman. He politely takes off his top hat — the red, white and blue one with the stars on it — introduces himself and clears his throat.
“Mr. Farmer,” he says to you. “I’m going to give you a choice. Either you can pay me tax right now on that little bag of seed you have in your hand, and I will consider it a done deal, and I will go away forever and leave you alone, or, you can pay me no tax whatsoever today on the seed, but I will come back every year and tax you on the harvest.”
“Let me get this straight,” you say. “If I pay the taxes on the seed today, I’m done with it forever?”
“That’s right,” says the taxman.
“But you will let me slide on paying the tax on the seed today, if I agree to pay you tax on the harvest forever and ever as long as a crop comes in?”
“That’s right,” says Mr. Taxman. “So, what’s it going to be?”
It’s a no-brainer, isn’t it? You will choose to pay the tax on the seed. Otherwise, each year, when the ears of corn are ripe, Uncle Sam comes by and taxes you on each and every ear of corn you pull off, and repeats the process for years.
It’s that way with Roth 401(k)s. You pay the tax going in, but never pay taxes again on either that money or the amount by which the account grows. So, since Roth 401(k)s are clearly more advantageous to the long-term saver/investor, why aren’t more companies offering Roth 401(k)s to their employees? Good question.
The excuse heard most often is that it would require more administrative help. I tend to doubt that is the real reason. I believe it is a lack of public awareness. Not many employees understand the benefits of such a plan, if they even know that it is available to them at all. Once enough people in the American workplace become aware, however, they will ask about it, and companies will feel the pressure to keep up with the times. After all, the reason why companies provide retirement programs to begin with is to attract loyal, competent employees who will stay with them for decades.