Why a 401k is a bad investment!

Sounds like a bold statement, right? Of course I should invest in a 401k! Planning for retirement is one of the most important things you will have to do. As we all know, you can’t live off of Social Security, assuming there is even Social Security benefits available for you once you are ready to retire.

Ok, so what is the article all about? Hesitantly, I believe there are some people that shouldn’t invest in a 401k, at least not right away. Why would I say that? Let me explain. If you have credit card debt, or any other consumer debt, you probably shouldn’t be investing your money anywhere. There are four things that must be done before you are ready to begin investing for retirement:

1. Stop living paycheck to paycheck.
2. Begin budgeting your money (and STICK TO IT).
3. Get out of debt (your home being the exception).
4. Create a liquid account to cover three to six months’ expenses

Why should I wait? Don’t invest for your retirement! Well, here is the reason. If you have a credit card or a loan at say a 9% interest rate and you invest your money and only make 10%, then in affect you have only made 1%. This doesn’t count inflation, which has been ~3 to 5% on average, so now you are down anywhere between 2 - 4%. So, why invest in a 401k where you are not guaranteed to make enough to cover your interest and a sizeable gain.

Looking at it another way, if you were to pay off that same debt, you would in effect be making a 9% return. The other reason why I say you shouldn’t invest in a 401k right off is that if you don’t pay off your debts and put money into an EMERGENCY FUND, that 3-6 months of income mentioned earlier, you may always be in trouble. If you were to just pay off your debt and not have a backup emergency plan, you would have to keep taking money out on your credit cards every time an emergency came up. Now you are stuck in a revolving circle of debt. Not a great place to be, and can leave you feeling overwhelmed.

Now, with all of that being said, you would be a fool not to invest in a 401k plan if you have met the four requirements above. Assuming you are ready to invest, the first thing you should do is see if your employer will match your investment into the 401k. Many employers have some form of matching. If you work for a company that matches 2 for 1 then that would mean that for every $1 you invest into your 401k, your employer will invest $.50. Before your money is even invested, you have already made a 50% return; not too bad. However, make sure you find out about the vesting period. Usually you have to work a certain number of years before the employer contributions are vested; giving you access to all of the money the employer has contributed.

There are many advantages to investing in a 401k. One of the great advantages, that is normally overlooked, is the simple fact that they auto deduct the contribution from your paycheck, making it easier for people that lack the discipline to save their money once they receive it. There are also tax advantages to investing in a 401k plan. Generally, contributions to your 401k are made pre-tax, which saves you the amount contributed times your tax rate. For example, suppose you have an income of $100,000 without contributing to your 401k. If you contribute $10,000, then your taxable income will now be just $90,000. If you were taxed in the 30% bracket without having made the contribution, you would owe $30,000 in taxes. If you make the contribution however, you would only pay $27,000. You save $3,000 in taxes for contributing to your own

Now I realize that this is all very generalized and it wont apply to everyone, but it should help you get started on creating a long term savings and investment plan. If you have any questions, please feel free to ask. However, if you are ready to invest your money and don’t know where to start, take a look at FeedTheBull for some great advice or to ask any questions you may have.

May 21, 2008 |

Comments

7 Comments so far

Allen Taylor May 21, 2008 8:34 am
Nice writing. You are on my RSS reader now so I can read more from you down the road.

Allen Taylor
RealWorldMom, Moms May 21, 2008 10:10 am
Great advice! I honestly never thought about it this way, so I appreciate the information!
antman, Antman May 21, 2008 12:01 pm
Hey bro, nice post. I would be curious how an employers match impacts this decision. If you get a 10% match and it is pretax that is an automatic 20% return, before market returns. That is hard to scoff at. Thoughts?
FeedTheBull, Investing/Financial Planning May 21, 2008 2:25 pm
Antman,

Absolutely. The above scenario is just that, a scenario. It is a great place to start, and it is something that you may or may not hear from a financial adviser (which I am not). You need to look at your individual situation and see what makes sense. The problem is that too many people get caught up in the cycle of debt and can never get out of it. I may write up a post on great ways to consolidate your debt, but like I said, I am not a financial adviser, just good with money and love to invest in the market.

As always, please consult a professional before making any life changing decisions!
Deb (Missives From Suburbia) May 21, 2008 11:41 pm
I agree with this 100%, and I think this is a great article. Unfortunately, it’s not real-world for most people. It’s predicated on the idea that people would take that extra money and pay down their debt. The reality is that most people let their debt ride, regardless of how much take-home they bring in, so they’re better off stowing their cash in the 401K and never seeing it. Not to mention, a lot of employers match contributions, so they’re passing up free money in the process. Plus, you can borrow against a 401K in the event of a hardship. It’s a lousy option, but better than credit cards in a pinch.
Curt August 4, 2008 3:50 pm
I agree, 401k plans are a bad idea for most people. To make matters worse, now people that have no savings are borrowing against their 401k. What are we doing?
david October 19, 2008 8:19 pm
The 401k is a goverment sponsored savings account. Why would you want the gov as a ’silent partner’ in your retirement plan? Here’s more. As you tuck away your money do you get use? No. Do you get growth? yes, a little. Do you get use and growth together? No. This plan does not pass my investment test. There is a reason why 10 percent of the people in the U.S. own ninety percent of the weatlth. Ultimately, wealth is created from within.