Is It Worth Investing in a 401(k)?

Transcript

Paul Winkler: And welcome to The Investor Coaching Show, Paul Winkler, talking about money and investing, looking at that period in your life, where you switch from working for money to where money works for you, always something to talk about in that area.

A Bit About 401(k)s

Can you talk about why you save in a 401(k)? I don’t know. That’s kind of a simple thing. Yeah, let’s do that. Let’s talk a little bit about why you save into a 401(k) or a 403(b) or a 457 plan or an IRA or whatever. They’re all basically the same as far as tax, but maybe differences as far as how the contributions go in from a, a matching standpoint there, you know, you can have tax, you can post tax, you have Ross features and things like that.

And, but you, you know, I might have differences in amounts of money that you can put in, you know, the contribution limits on various plans can be different and things like that. But, you know, in general, it’s I thought, you know, that’d probably be a good way to start off the show. Talk a little bit of why we don’t save in 401(k)s? What is the big deal about a 401(k)? Why is this such a popular investment vehicle for retirement planning? And you know, what I started with is, well, why did we save it all? And I saw this, it was a survey of people and they said, okay, so what are the biggest concerns, biggest retirement concerns for Americans in their fifties. You know? So what do people worry about when you’re in your fifties?

Well, you probably can go. Yeah, I know what I worry about. Yeah. And number one on the list was social security running out 65% and then talked a little bit about social security. You know, the fact that you had so many people working for every single person in retirement now it’s less than three, you know, so you have a big concern that there was more money going into the social security system than coming out of it in years past. And we’re getting to the point where we’re going to start to tap into that trust fund. And the worry is that they’re going to run it down, you know, 20, 35, 20, 34, whatever, you know, there are all kinds of projections as to when that’s going to run out, but that’s, that’s concerning people have, it’s going to run out.

Well, the fact is, and you’ve heard me say this before. If you listen to the show, the 70% of promised benefits will still be payable, but, you know, we’re looking at a 21% reduction in benefits if they don’t do anything to fix it. So that’s one of the concerns that people have. Another one I’m paying daily, living expenses. Fifty percent of people are concerned about that. If they’re paying medical medical bills, 47% outliving savings, 46% about half people not being able to retire at all 33%, having too much debt. I guess if you’re, if only a third of people are worried about being able to retire, then the rest of those people aren’t worried about, well, yeah, we’re gonna figure it out.

People Will Retire

They’re going to retire, regardless of whether they’re going to outlive their savings or pay their medical bills or pay their living expenses or social security running out, having too much debt was another concern about a quarter of people and feeling bored or lonely was about 16%, which is just an interesting, I think to me, and one of the points I made was that, well, if you think about it, all of these problems are solved except for feeling bored and lonely. Well, that can be somewhat solved by this, by making sure you have enough savings, because if you have enough savings, you can get out and do things so you’re not bored and you’re not lonely. So all of these, these things are solved by saving. So it’s a really important point, you know, money for the future. And the idea is what you do is you take income that you don’t need right now.

And you defer it to a point in your life where you’re going to need it more when you’re not working anymore. So say, okay, I don’t need this money right now. We all can find ways to spend money and we can all make it up in our minds that we do need it, regardless of whether we really need it or not. We make it up in our minds that we need this amount of time. But the reality of it is that you’ll probably need it a whole lot more in the future when you don’t have any income coming in. So, you know, put it away right now. And what we do is we choose not to pay taxes on that income right now in a, okay, I can say, Hey, you know what? I don’t really know, need this income right now, but I will need it more in the future.

So I pay taxes on income that I don’t “need” right now, I’ll push it off in the future. And what happens has made me right now, you’re at a 22% marginal tax rate, which is, you know, some of your income taxes. As your income goes up, your tax rate percentage goes up. Now your earlier income is still taxed at the lower rate. It’s just your later income or your, or the last dollars you earn that are taxed at the higher rate. So let’s say if you’re a 22% marginal rate, $100 becomes $78, before your social security taxes. Now, if you’re retired and you’re married, filing jointly 2021, it’s $25,100 of income is taxed at 0%.

Well, $45,000 of income. What’s the average rate on that? Well, the average rate is 4.4%. So you look at that and go, Oh, okay, well, that’s a lot lower than the 22% that I would have paid taxes earlier. So yeah, it may make sense to avoid 22% now and take it at 4.4 in the future. So that’s the idea behind a 401(k) traditional 401(k) says, don’t pay taxes now, pay it later.

And you know, some people, all the tax rates are going to be higher in the future. Well, yeah, they’re very possible for very high income people because that’s who Congress goes after.

You know, it’s an unfortunate fact of life, right? So that’s why you do tax diversification. You have some stuff that’s pre-tax and some that’s post-tax and, and hopefully, you know, you can play them off of each other later on and save yourself. So that’s why the pre-tax 401(k) has been such a popular thing. And, you know, let’s say if we take a person saving $4,000 a year for 30 years, and let’s say, we’re looking at 4,000 of gross income, and they’re saying, I’m going to take 4,000 of income before taxes. And I used an example of 7% return.

Inflation Numbers

So I took seven because I like to use after inflation numbers when I project. So I can think about the number that comes out in today’s dollars. If I go and take the full percentage, 10% return, 12% return, I’ve heard people do that before. And I just shake my head and go, you know, you’re going to give people a false sense of how well they’re going to be doing when you project out returns that high, because they’re going to look at the number and go, Whoa, I’m going to be really, really rich, but then you have to go, well, how much will that amount of money by in 30 years? So I like to go and net down the return to an after inflation number, it’s just easier to help people think in today’s dollars when you do that.

So let’s say we did that 7% return. And a, and we look at, let’s say putting money in $4,000 of gross income. Well, if I’m in a 22% tax bracket, I got to take that $4,000 and net it down after taxes to about $3,100. So I take the $3,100. And then if I put it in a taxable investment as 7%, and I paid 22% in taxes on that, well, that’s a 5.4% about a 5.5% rate of return. So now I go 31 20, I’ve got less money because I had to pay taxes on it before I invested it, earning a lower rate of return because I have to pay taxes on the gains.

And you end up with $4,000 a year, over 30 years of gross income going in, net it down to 31, 20 and so on and so forth, just with a little over $200,000. Okay. Now what if I go and put that money in pretax, save it. And then I pay taxes on it at 4.4 coming out 4.4% average rate using my example. Well now just about double close to double the amount of money over that period of time, over 30 years. Well, what if I have a match on it? I have what’s called a safe Harbor plan and I’ve got a match on it. Now I’ve got money. That was, you know, number one, put in pre-tax, then the employer matches the contribution.

And now it’s over a little bit over $500,000 in my example. So you look at that and go, wow. Okay. So that’s a huge difference in income in retirement because I go and put it in and not don’t pay taxes on it today and pay taxes on it in the future at a lower average rate, and you got to match it, you know, so a lot of things make a 401(k), a really good idea. The other thing about it is this, and this is something I like to teach a lot, is that if we look at 401(k)s, it makes the process yes. Automated, you know, and if you don’t have a 401(k), you can automate it by bank drafting, money into an IRA, you know, so you can have your own account and do that.

And you can do that with, you know, other types of retirement plans as well, but you can automate the process. And it’s a good idea to do that because here’s the thing about humans. We have a tendency to fall in one to two categories, either we spend first and we save what’s leftover, and that’s where, that’s where most people end up, you know, I spend and I go, well, if I got any money leftover, I’ll save it. And I always like to ask, do you ever have anything left over? No, no. I, I usually don’t have anything leftover cause it can find something to spend it on. Right. And it’s just no matter what it is I can, or I can save first and I spend what’s left over. Now, if I do that first, and then I say, okay, everything after that, I can go and spend.

And the beauty of that is that if I think in terms of that, I say first, then it’s nobody’s business. What I spend the money on afterwards, you know, when people say, well, you always have to have a used car. You always have to have an old beater. You always have to, you know, well, the reality of it is I can, if I really feel like it and you know, maybe we can make a case that economically it doesn’t make a whole lot of sense to always buy new cars. But if I’ve saved first and I’ve done that and I’ve done my due on saving money first, then you know.

So I don’t necessarily think in terms of, you know, how can I get somebody to have the most amount of money that they possibly can. Yeah. I don’t like to think in terms of that. So I like to get in other people’s business, maybe that’s it. So, you know, you look at it that way and you go, well now, what else can you avoid by having saved that way? Well, there was one study that showed that nearly four, three and four people plan to continue working after claiming social security benefits. Well, you know, if you have saved, maybe you don’t have to work. You can work because you want to, not because you have to. Then I was looking at other studies and just saying, well, you know, what are the average and median 401(k) balances by age in the United States.

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Medians

And if you’re between ages of 22 and 24, you don’t typically have a whole amount a whole lot. It’s more than I thought it would be about $20,000 in a 401(k). It’s more than I would’ve thought it would be. Median is about 11. Now, typically when do we use average balances versus median in statistics? A lot of times you’re going to use the median number because that means that half people are above this number and half are below average. Just take how much money is in 401(k)s and divide it by the number of people. And average can be really misleading because you have some people with huge 401(k) balances that skew the number really high. Now median just takes half are above this number and half are below and it takes out some of that skewing.

So a lot of times you’ll see that in statistics you’ll use the median number. So, you know, they feel 25 to 34. It’s about 77,000 is the average and 47,000 is the median. If you’re between the ages of 35 and 44, I’m just going to use the median from now on. Now let’s take that because we were talking about people in their fifties. If you retire with that amount, that amount of money, how much income you can, you take about 12,000 a year, you know, using a 4% distribution rate and you can increase that for inflation every year.

You know, historically, that’s what the research is. If you follow the rules. Now, a lot of people don’t follow the rules anywhere near as matter of fact, the investment industry is terrible at following the rules that came up with a 4% number that I’m talking about. So, you know, just take that with a grain of salt because, well, we follow the rules, but let’s say that you look at the typical investment management firm it’s not happening or the typical investor, but anyway, just using that number because it’s available and you can, if you follow the rules, that’s about, that’s still only a $12,000 income. If you look at 65 plus, this surprised me, people over 60, 165,000, is the median amount of money in a 401(k).

And part of that’s probably it could be because 401(k)s weren’t available when they were younger. So it covered a lot of territory, man, you know, what is the point of a 401(k) plan? You know, really it’s a popular plan for a lot of the right reasons and why we use them. And one of the things I want to make them point out is don’t get too overly married to, you know, employers plans and, you know, people think, Oh, you know, my employer, must’ve vetted these investments really, really thoroughly. And the reality of it is a lot of times it’s just a popularity contest. Some of the investments in your 401(k)s can be actually kind of not so great. The level of diversification could be very, very low.

Watch Carefully

You got to really watch carefully, you know, these target date funds that you always see, right? Realizing that, you know, a lot of times they’re not very well diversified at all. A lot of times you have to take matters into your own hands. And even when you do that, a lot of times you don’t have the level diversification available to you in the 401(k) that you will necessarily elsewhere. So yeah, a lot of times the expenses are very, very low, but many times fun. They will cut corners in the management of the portfolios. And you’ll hear me talk about how index funds like cap weight, weight based on the size of the companies, bigger companies are represented, where do we expect more return now, smaller companies, you know, a lot of times the value companies they’re over at weighting, big companies.

They’re what do we expect? More return, more value-oriented companies, which by definition should be smaller companies. And they’re over-weighting the bigger companies. So you really have to be conscious of how the 401(k) is, what together and you know, how the investments are chosen. A lot of times you’ll find that investments are chosen by, based on past performance. And I saw it, it wasn’t that long ago, we saw a lot of commodities funds in portfolios, will commodities have no expected return after inflation? You know, if we go back to the 1900s, we see that, you know, for example, gold is a commodity. You’ve heard me say this before. If you’ve, if you’ve listened to the show that gold an ounce of it would buy a good men’s suit. Nowadays, an ounce of gold buys a good men’s suit, no gain whatsoever. You’ll see real estate investment portfolios now.

And the reality was there, lots of risks. And, and the fact of the matter is that real estate can fluctuate significantly, especially when you have interest rate changes. As, since we’re starting to see now, sorry to see interest rate changes and where they lead. You know, you don’t necessarily know the other thing that we see as this, we’ll see different asset classes come in and out of favor and 401(k) plans. You know, it wasn’t until After small international values or a small international, they didn’t do value yet. It wasn’t until after small international stocks knocked the socks off of everything else out there that Vanguard even came out with a fund investing in that area.

And then when they came out with one, it was a lousy one than an international small vet. You don’t even see that asset category, international, small value stocks and portfolios. And yet it’s one of the areas of markets that you’d have the highest long-term expected returns, emerging markets, forget about it.

Sometimes I even tell people to use the 401(k), even if you don’t have a match. Why? Because it’s the simple discipline of deferring some of your paycheck. That can be a big deal, you know, taking some of that paycheck and just having income out before tax and, or, you know, if you use a 401(k) with a Roth feature, sometimes it does make sense to use that if you’re in a really low tax bracket now, or likely to be in a higher bracket in the future, that may make some sense. So those are some things you gotta think about, What’s my tax bracket? Now, if I earn another dollar of income, what’s the tax rate going to be on it versus what I’m going to have as a tax rate in the future.

You know, I may have this big inheritance coming my way, or I may have a tremendous amount of money or a pension plan or something like that. It’s going to drive my tax bracket up later, maybe ought to use a Roth feature if that’s going to be the case. And what are the different investment vehicles I have? So many times they’re chosen based on past performance, you know, emerging market stocks, all of a sudden I had 401(k)s with no emerging market stocks and then emerging market stocks did really well. And what happens when the employer says, we need to add this in our portfolio. It’s a lot to realize. A lot of times they are reactionary. They react after and they respond after the fact with adding asset categories to 401(k) plans.

So you have to be very, very conscious of that. Sometimes 401(k)s aren’t the best thing, but the automatic feature, being able to defer income, not pay taxes on the gains, outweighs a lot of that stuff. Many times realizing that maybe later on when you have a separation from service, that there might be better alternatives out there. This is The Investor Coaching Show.

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