In last week’s post, my colleague, Justin Hong, discussed his qualms with the 401(k) system. While he raises several good points (such as broadening your financial knowledge and diversifying your assets), he dismisses several benefits of organized retirement plans.
In the following article, I hope to refute Justin’s 401(k) “cons” list in order to create some friendly financial discourse.
Justin says: “The limitations of standard (and marginally lucrative) retirement plans…”
Marc says: 401(k) plans are actually quite lucrative. Say I have $10,000 from my employer that I can either push into a 401(k) or use for my own personal investments/spending:
The $10,000 in a 401(k) begins earning compounding interest on the full $10,000 from the minute it’s invested. Let’s assume the $10,000 only makes a moderate (but acceptable) 6.5% interest a year, the opportunity to grow interest on “tax-free-dollars” today (versus taxed personal investments) works in your favor.
Let’s take a closer look at this:
Scenario 1 – 401(k)
Calculated Compounded Interest
1.065 (interest) ^ 5 (years) = 1.37
Compounded interest refers to the dollars from interest earned during the beginning years, which can continue to grow interest in later periods.
Total Investment after 5 years
1.37 *$10,000 (original investment) = $13,700
Scenario 2 – Personal Investment
If you were to collect that $10,000 from your employer to invest on your own, Uncle Sam would nab you with those taxes he loves so much. From the get-go, you’re beginning with less, which means less to grow on the long run. Let’s assume a 35% tax rate (average effective tax rate).
Remaining amount to invest after taxes
$10,000 * (1-.35) = $6,500
Needed interest rate to reach $13,700 after 5 years
a) X^5 *$6,500 = $13,700
b) X^5 = 2.1076
c) X = 1.16 or 16%
If you were to decide to put the money to work on your own, you would need to earn almost 3x a return, meaning 16% compared to 6.5%, in order to reach the same amount in 5 years.
Justin says: “By putting your extra money into a retirement account, you’re not challenging yourself to learn how to make money.”
Marc says: Just because you’re putting money away for your future with a 401(k) plan doesn’t mean you can’t challenge yourself to make more money on your own with additional ventures and investments. 401(k)s are not out to get you. They are simply incentives from your employer to lessen their pension payout burdens and help you save for the future.
Justin says: “Take risks.”
Marc says: The financial crisis of the 2000’s was largely due to families living beyond their means. It is safe to say, in this current economy, your money would be better spent in savings than frivolous trial and error investments.
Not included in the example above is the principal that 401(k)s generally have matching contributions from employers. Most employers match investments up to certain thresholds, with some of the more generous ones paying 50 cents on each dollar spent by their employees. THIS IS FREE MONEY. If you do not invest this money in a 401(k), you do not receive your employer’s match.
If you add in a 10% match from your employer to the previous example, you would have originally started with $11,000 instead of $10,000. After five years, you would have made $15,070 and needed to generate a comparable year-over-year return of 18%. If you know anyone guaranteeing a five-year return at 18%, PLEASE LET ME and Warren Buffet know, because that’s where we want to put our money!
Marc Vitulli is a licensed CPA with a Masters degree in Finance and Accountancy from the University of Illinois. Marc blogs on financial and entrepreneurial topics for eCreditCards.