I used to think our company’s 401(k) program was a great deal . . . for our employees as well as our company. Now I’m convinced it is a raw deal. Especially for our employees. (Though I have serious reservations for the company as well. But that’s for another time.)
Sadly, so far, I’ve been unable to convince the management team to get something better. And, I’m afraid, too many of our employees are enamored of the program as well. (I’ve been told: “If you didn’t have a 401(k) plan, I wouldn’t have come.” —And this from a financial person who ought to know better!)
So let me tell you what I have learned in the last couple of years that has turned me so strongly against the standard, government-approved, defined contribution plans. . . .
Oh, What a Partnership!
Somebody once said, “When you sign up for a 401(k) or an IRA, you have two partners. One of your partners is whoever is managing (or operating as the custodian of) those funds. The other partner is the government.”
Now imagine you’re about to go into business with two partners and you’re ready to write up the agreement. Is this the kind of agreement you would write?
You Put Up All the Money and Take All the Risk; Your Partners Make All the Rules
Would you ever say to your potential partners,
Okay. Here’s what I’m thinking.
- I will fund this entire partnership. I will put up all the money.
- I will take all the risk of loss.
- You, oh government and manager/custodian(s), will determine what the partnership will be permitted to invest in . . . though I will retain the right to further specify what I’d like to invest in within the bounds of what you have set for me.
- You, oh government and manager/custodian(s), can “change the rules,” as it were, concerning the range of investments I’m permitted to choose from.
- I guarantee never to take out any money that I put in unless and until you, oh government, tell me it’s okay. (I understand that, at present, you’re willing to let me have my money after I’m at least 59½ years old. But you could change the rules at any time.)
- If I break the immediately preceding promise, I will pay penalties that you, oh government, will set in my behalf. I understand that, though the penalties are 10% at the moment, you can change those rules whenever you want.
- You, oh manager/custodian(s), will get to remove at least 1% . . . and more likely 2½% or more of the value that sits in our partnership every year—indeed, you can remove an appropriate proportion of that yearly total every month—whether you make me any money or not. Even if you lose money: you’re still guaranteed to collect your percentage.
- You get to make all the rules about how this partnership will operate.
- You can change the rules at any time.
- As I have already noted, you can tell me when I’m allowed to have access to my money.
- You can tell me when I must take possession of my money. (Currently, age 70½.)
- You can change the penalties I will have to pay if I break any of your rules.
- Oh! Very important! Before I take possession of any of my money, I will pay you taxes—at the going rate for regular income whenever I do take possession of my money (assuming I get access). And, of course, you get to determine what that rate will be at any time in the future.
Sound like a good partnership plan to you?
Want some more good news?
How Onerous Are the Rules Today?
Here are a few of the “rules” that the federal government has put in place at this time. Do you think they are likely to get better in the future?
- You can see what we’re currently charging people today when they want to exit, but who’s to say that we’ll be charging the same rates 10, 20 or 30 years from now when you decide you’d like access to that money?
- You say you’re just starting out? You’re 25 years old right now, earning at (what we would assume is) the lowest level of your life. You’re subject to the lowest income tax rate you are likely ever to experience. We will be happy not to charge you any income tax on those funds now if you will put them into the partnership. In 40 years, however, when you are almost assuredly going to be in a higher income tax bracket (and we will almost assuredly have raised the rate for income tax—at least for successful people [which we hope you will be]), we will be happy to take our cut at the higher rate we have determined for you at that time.
- This partnership—besides ensuring that the manager/custodian and we, the government, make a good income— . . . This partnership is to ensure you have something available when you retire. Right now, we think you ought not to retire before 59½. So if you want access to your money before you turn 59½, here are the rules:
- We will let you touch no more than $50,000 prior to when you turn 59½ or you will pay a 10% penalty.
- You may borrow up to $50,000 (or half your fund’s balance—whichever is lower) without paying a 10 percent penalty, as long as you pay it all back within no more than five years. (If you borrow for a house, you can keep the money out longer.) HOWEVER,
- You must normally begin paying back the loan with your next paycheck.
- Even though you are borrowing the money that you put into the account, you will be charged interest on your loan.
- If you leave your job for any reason (or if it leaves you: i.e., if you are let go by your employer), you must pay the entire loan back within a short period of time—usually 60 days. If you can’t pay it back, everything you fail to pay is considered a distribution from your account. It will be counted as income to you in that tax year (which could bump you into a higher income tax bracket?), and you will be charged not only the income tax but the 10% early distribution penalty as well.
- You had some further questions about possibly borrowing from your account? Really?!?
Please. You really, really don’t want to go down that path (as more than 25% of 401(k) account holders have gone before you). Indeed, we are so upset by how foolish you and your peers are, we have been discussing the possibility of raising the penalty to 20%.
Oh. You had some questions about the taxes associated with any loan you take out?
Yes. It is true: you won’t be able to pay back your loan with the same kind of pre-tax funds you used to invest in our little partnership to begin with. You will FIRST have to pay current income tax on all your loan principal and interest. And you will not only pay tax on those dollars as you repay the loan; you will then pay tax on those dollars when you take them out as a distribution after age 59½.
—And you wonder why I think maybe—just maybe—the defined contribution plans are a raw deal?