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Understanding the 401K

by Ouida on March 21, 2010


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I’ve been thinking, which is always dangerous, about the 401K. What really started me thinking was a conversation that I had with a friend of mine over a Cashflow game. She invests in real-estate as do I. With a young family and being the primary bread-winner,my friend spent countless nights up reading personal finance books. The conclusion for her: That the 401K as a retirement vehicle made no sense for her. Why? Because the 401K turns gains that would qualify as capital gains into gains taxed as ordinary income. The only way to “win” the 401K game in retirement is if you plan to be in a lower tax bracket in retirement than you were during your working years. Some folks call that planning to be poor. I think I can be a bit more generous than that. Honestly it only makes sense to me to plan to be in a lower tax bracket if you can guaranty the following: 1) you will own your home free and clear. If you don’t own a home and there are many good reasons not to, you will have an ongoing housing expense in retirement 2) Your children grow up, leave the house and never, ever need financial assistance from you 3) You are extremely healthy in retirement and will never need a hospital, assisted living or long-term care facility. 4) tax rates will not increase in order to offset growing budget deficits. In other words if you can guaranty that your expenses in retirement will be lower than your expenses during your working years, it may make sense to plan on retiring on less income than you are accustomed to earning. It is important to understand what the 401K is and where it came from. 401K simply refers to the section of the IRS code that allows for the creation of the 401K deferred income savings plan. Deferred compensation means that you defer receiving some of your income today and in exchange for that you lower your immediate tax burden. In exchange for lowering your immediate tax burden you agree to pay ordinary income tax on the money you withdraw from the plan. The truth is that prior to the creation of the 401K, deferred compensation arrangements were in existence and were created to allow high income wage earners to defer non-scheduled income to reduce their overall tax burden. If you are in the 35% tax bracket when the money goes in and you remain in the 35% tax bracket when the money comes out, you will pay 35% tax on the money. If you are in the 35% tax bracket when the money goes in and you are in the 25% tax bracket when the money comes out, you pay 25% on the money in your 401K. If you are in the 25% tax bracket when the money goes in and in the 35% tax bracket when it comes out you pay, guess what.
The 401K is a savings vehicle. A savings vehicle with many strings attached. Withdrawals prior to 59 1/2 are subject to an early withdrawal penalty of 10% in addition to ordinary income tax. While there are ways to avoid the early withdrawal penalty, but unemployment is not one of them. As a savings vehicle, the 401K is pretty illiquid. If you are unemployed and your primary source of savings is your 401K, you will with- draw at ordinary income tax rates PLUS pay a 10% penalty. The employer match is supposed to be the be all and end all of the 401K. In other words the employer pays you to save by giving you free money up to a certain percentage of pay. For those employers who offer a match, that match can range from 3-4% of pay. But employers don’t have to offer a match and many employers will suspend their match during hard economic times which is exactly what happened during this most recent downturn. For those companies offering a match there may be a vesting period of 3-5 years before employees can keep the matched funds. I have had many friends over the years who have suffered intermittent unemployment, with the 401K often being the largest if not the only source of savings, it gets tapped with now unemployed person responsible for penalties and income taxes. Given that the 401K is a type of deferred compensation savings vehicle originally designed for high income individuals, I have been wondering if this is the right vehicle for everyone especially middle income individuals or individuals with spotty employment histories for whom liquidity might be the most important concern.

What are your thoughts? Do you have a 401K and do you believe it is the right savings vehicle for you?

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