While driving home yesterday I was listening to a talk call-in show and during the show I heard the announcer recommend that the caller max out her government sponsored retirement plan (ie 401k/403b/IRA).
I guess to most people this would not be shocking advice but to me it was very shocking. The announcer did not ask the callers age (though she sounded fairly young 20-30's). What other debts she had (he did ask about credit cards). Or if there was any major expense coming up anytime soon.
I see what happens on the other side of this advice. The problem I have with 401k's or other government sponsored plans is that no one seems concerned about the biggest pitfall of these plans which is they essentially lock-up your money to age 59-1/2. Most of these plans have very few choices about where to put your money and many have no 100% safe options. Also as I have found out time and time again no one knows what the total fees they are being charged. Even worse almost none of these plans offer what's called an "in-service" withdrawal, so the only way to get money out of these plans is to quit or become totally disabled. Finally even after all that most of these dollars have not been taxed so if tax rates go up all of the benefits of "tax-deferral" could be lost.
What's most disturbing though for people in my generation is that contributing to a 401k actually leads to other costs (in economics they call this "Lost opportunity costs"). A couple that is 35 have $100,000 in a 401k, $100,000 in home equity and $15,000 in a checking/saving account. They need to finish their basement to move their office downstairs, so they can make room for a nursery for baby #2 upstairs. They estimated this project will costs about $50,000. Where do they get the money...their 401k...no they would have to pay a 10% penalty and taxes (let alone if they even have access to it). Most likely they would get it doing a home equity line of credit. So think about this for a moment: they have made extra payments to pay down their debt only to have to pay interest on their own money again?
They pay $10,000 cash from savings and take a $40,000 loan @ 7.5% for a payment over 10 years of $474.81. Their total payments equal $56,977. Or in other words they paid a volume of interest or their "lost opportunity cost" equal to $16,977. At 5% (this is the rate of return we could gotten on our money if we had saved it and not had to spend it on interest) compounding for 40 years to age 85 (average life span) equals $125,000.
In other words because they did everything right and gave up control of their money willingly in their 401k, and to a certain extent their home equity, it costs their lifetime wealth about $125,000 not to mention the additional stress of the extra payments during those 10 years.
I'm not up to doing the math (way too many variables) right now, but the other side of the coin also has opportunity costs associated with it. How much would the opportunity cost be for not putting in enough money (from years 31-35) into the 401K to be able to have this 40K available at year 35?
ReplyDeleteA 401K, whether or not always correct, is a better solution for many people as it is automatic. I haven't had an issue putting money there, but funding a Roth out of take home pay just hasn't been done.
Randy,
ReplyDeleteThere is this otherside of the coin as well. If I don't save money today I will have less tomorrow, I think most people understand this point. I guess the argument I am trying to make is that there are many places to save money. The 401k is not the only option. I also believe at least for most responsible people they would rather have control and use of their money of which the 401k gives neither.