401(k)s a Scam? Hardly.

I like James Altucher.

I'm not even sure why. He's a bit of a self-deprecating odd-ball, but has experiences you can learn from and is not afraid to share them.

I enjoy much of what he writes and he's on my shortlist of bloggers. But a recent blog post of his - Why Your 401K Is A Scam - is guilty of hype at best and poor advice at worst. Let's take a look at his arguments and shine a little common sense on them:

His PROs:
  • It builds a savings habit, especially when you are young
  • The employer match
  • Tax deferred earnings (Aultucher is focused on non-Roth 401(k)s here)
To this I'll add two more benefits:
  • Between 59 1/2 and 70 1/2 - you have complete discretion regarding timing of withdrawals (and, outside those parameters, some flexibility tempered by withdrawal penalties before and Required Minimum Distributions (RMD) after)
This flexibility lets you work around other earnings and taxable Social Security payments to minimize thetax impact of your 401(k) dollars
  • 401(k) assets are generally judgement-proof in case of a lawsuit
His CONs:
  • You can't predict your tax rate 30 years from now.
Tax strategy, like investment strategy, is not without risk. But in recent years, tax brackets have moved within a narrow band rather than moves that would render current strategies unwise. Couple that with the likely circumstance that some degree of warning would be given that would allow you to pull the funds (even with a penalty) before any overwhelming increase would take effect, and preservation of options seems a wiser choice rather than closing them off prematurely. 

Barring death (see below) or the blessings of an extremely long life, you will not have to pull the funds out all at once (see above) and be forced into a higher tax bracket.
  • The employer match.
Altucher argues the employer match is offset by lower wages and subject to vesting restrictions. Both true. But if this is the job you have, your employer is not going to pay you more if you voluntarily step back from the 401(k) (in fact, if enough non-highly compensated employees do so, it screws up the Big Bosses' 401(k) contributions). Avoiding the 401(k) will get you the same lower salary without the offsetting match.
  • Fees
This has been a big problem in the past. It remains so for many 403(b) plans (mostly non-profit employers) managed by insurance companies; so much so that for 403(b)s, it may make more sense to put incremental dollars into an IRA. traditional or Roth.

For the rest of us though, things have been improving. A large number of 401(k)s now have low cost index fund options and recent changes have mandated the explicit disclosure of management fees. Keep in mind the relevant comparison is not fees vs no fees, but fees charged by your 401(k) vs the cost of investing in a similar strategy outside your firm's retirement plan - a cost that is often comparable.
  • [Incorrect] Assumption on market returns
He's completely off-base here. The market is the market inside or outside of a 401(k). The gross returns for identical assets will be the same. The net returns will depend on expenses and the very item we are discussing here: taxes.
  • More on taxes [timing]
Altucher argues most taxpayers have higher deductions in their prime earnings years (dependents, business deductions and - though he is no fan of home ownership - I'll throw in mortgage interest deduction here). It has been my experience that lower earned income and medical deductions late in life at least counter-balance the aforementioned write-offs.

I'll add three more cons Altucher missed:
  • Traditional 401(k)s turn capital gains into ordinary income
Held outside of a Traditional 401(k) or IRA account, capital gains are taxed at a lower rate than ordinary income, but that advantage disappears inside a tax-deferred account and all your gains face the higher rate. If you are fortunate enough to have the flexibility, look to place your capital gains generating investments outside of tax-deferred accounts.
  • Your investment options are limited
Want to buy rental property? Invest in a private business? Commodities? Not inside a 401(k).

While some plans may offer semi-exotic funds allowing you to invest in Real Estate Investment Trusts (REITs) or foreign bond, most retirement plans do not offer the full range of investments.
  • You may not be in a higher tax bracket when the funds come out but your heirs might
Tax-deferred accounts don't have the most flexible rules for heirs, especially non-spouses. They may have to get the money out before you'd planned on it and, of course, it will come out based on their tax bracket, not yours.

In short, 401(k)s are not a scam, but another weapon in your retirement arsenal. When and how you should deploy them requires thought and planning.

If you're a Missouri resident and would like help with your planning, please visit us at www.comptonadvisors.com.

Compton Advisors, LLC is a Registered Investment Adviser (RIA) firm regulated by the Securities Division of the Missouri Secretary of State office. Compton Advisors, LLC does not render or offer to render personalized financial, investment, legal, or tax advice through this blog. This information is for informational purposes only and does not constitute financial, investment, legal, or tax advice. This information has not been approved or verified by any governmental authority.