Getting anyone to listen to a piece on retirement planning is difficult on a good day, and almost impossible when the audience is younger Americans. But the topic isn't as irrelevant as many young people think, because retirement planning isn't just about you — it is a family issue. The news about retirement planning isn't good, either, according to this report by the think tank Demos, "Broke Boomers and the Coming Crisis of Elderly Poverty." While you may have heard that the problem is that we don't save enough, the larger problem is the way we save.
For most Americans, their largest expense in retirement planning — Social Security — will lose money. Behind Social Security, many Americans use 401Ks to create the personal savings accounts that Social Security will augment. The problem is that the 401K can also be a money loser, with trade-offs that few understand.
401Ks have a place in an investment portfolio, but you should understand the rules before you invest through one. 401Ks are not tax-free accounts. They are tax-deferred. Tax-deferred means that you are trading the tax rate today for one that is unknown in the future. You will pay tax on the income at some point.
For money deposited today, that trade is largely a bad decision. The current tax structure is historically favorable, particularly for lower-wage Americans. According to the CBO, people in the lowest quintile of income pay about a 1% effective tax rate on income. In fact, many Americans pay 0% for long-term capital gains. So passing income through a 401K can create a needless tax liability where there was none.
Furthermore, few people consider the tax consequences of 401Ks, as evidenced by participation in Roth-401Ks. One reason that people do not follow these accounts closely is because these accounts reserve wealth for far in the future. Separately, employers pay employees to make the mistake. Some employers offer 100% matches of your contributions. Employees see that match as doubling their money.
How can free money go wrong? Fees. Fees hit younger Americans harder because the fees accrue over a longer period of time. How much are fees? Consider accounts earning 5% real (roughly an average rolling 40-year return). A dollar invested in 45 years without fees is worth more than $9. Two dollars invested in a 401K subject to 2% fees grows to about $7.50. The 100% match does not even cover the fees if you are 30 or under.
How much 401Ks cost depends upon where you work because fees vary from plan to plan. Brightscope.com, a retirement planning service, projects that workers of Darden Restaurants lose over $200,000 in fees, or up to 21 years of additional work. Demos projects that "over a lifetime, fees can cost a median-income two-earner family nearly $155,000 and consume nearly one-third of their investment returns." Every plan is different, and Brightscope.Com will tell you about the specifics of your plan.
What do you get for the money? Mostly you get the right to not use your money. These accounts require younger workers who tend to be less established to lock up their money for a longer period of time. In the real world, you are supposed to get paid to make extended commitments of capital. For example, the 30-year Treasury bond pays roughly 4% compared to 1% for the one-year bond. 401Ks do not compensate the holder for the commitment.
For millennials, the commitment means that your money is not available when your life changes. Whether it is to start a new business or for health reasons, you will probably need to dip into your savings sooner than you think. Putting your money into a 401K not only exposes your investment to the risk of the market, but makes it certain you'll be assessed penalties for early withdrawal.
For Baby Boomers, forced 401K distributions create the risk of triggering Social Security's means-test. The IRS applies a means-tested clawback of benefits on people who have "substantial" outside income. (In fact, up to one-third of retirees trigger this test). So it is possible that your savings will trigger a negative savings rate.
This isn't to suggest that 401Ks are evil or that anyone is stealing your retirement money. These accounts are a structured investment tool, with costs and rules. If you don't understand the costs and rules, you could pay a severe price.