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Why Investing in a 401k is a Bad Idea

By: Curtis Ophoven

8/5/2008 - 20 Comments

Almost everyone I know believes in and invests in their 401k, yet I believe it’s a bad idea and here is why.

I’ve heard all the arguments about why everyone should take advantage of their 401k and at a minimum match their company’s contribution. If you don’t, you are losing out on ‘free money’.  The ‘free money’ idea is based on the fact that when you put in $300 per month and your employer matches your $300, than you are giving up $300 in free money.

The 401k plan was created by the government with good intentions to help encourage people to save more money for retirement. The plan included several financial incentives and trade-offs for both employers and employees. The reason employers are willing to contribute to your 401k is because they can avoid many taxes that they would have had to pay if they directly gave you the money and they can still include the full amount in your benefits package. In fact, companies save so much money with these plans that they encourage everyone to sign up for them.

The true cost of investing in your 401k cannot be known until you retire, which is sometimes 30 or 40 years away.  I find it ironic that people so easily trust their hard earned money to a savings plan in a nation that is only 220+ years old and has had several major financial meltdowns.

Here is a list of reasons not to contribute to your 401k plan:

  • Loss of opportunity for 30-40 years
  • Inflation (the dollar lost 2/3 of its value just during the 70’s recession)
  • Taxes are likely to be higher when you withdraw your money
  • False sense of security, which increases a tolerance for debt and promotes bad spending habits of living beyond ones means
  • Many plans are littered with hidden fees
  • Loss of control with limited investment choices
  • Stock markets are risky and shouldn’t be invested in without a financial education

A Better Option

A better option would be to pay off debts and create a savings account at your local bank.  There is a good chance that you will need an emergency fund someday when your company decides to downsize or your job gets outsourced.  If you have a savings of 6-12 month of your income, you will save a lot of money just by not having to borrow from your 401k or suffer a major financial loss like a foreclosure.

Saving for retirement before getting out of debt is a foolish idea - even with a company match - that will likely be gone by the time you take the money out anyway. The only good that the government created 401k savings plan has brought is that it provides the stock market with a base that cannot be quickly sold.  That base, which is missing from foreign markets, is why the market cannot dive 50-70% very quickly.

They Always Say - Start Early

When you ask a financial adviser when you should start investing for retirement, what do they always say? ‘Start Early.’  Well, this is bad advice and here is why.  When you get out of college with 50K in loans and a 10k car loan and you start looking at a new house, you are broke.  Investing for retirement when you are this far behind is not a good idea, because all it does is help you live with your debts.

At this point, most financial advisers show you a graph of compounded interest to prove to you the earlier you start the better.  But, what they don’t tell you is that your debt interest is also compounding against you.  If you save 100k in your 401k with 100k in debt, both interests are compounding and you are not getting anywhere.

A better idea is to first get out of debt, second build a savings account and then carefully consider your options for saving for retirement.

Besides, if the biggest advantage to a 401k plan is that your income tax is deferred until you withdraw the money in retirement, then doesn’t it make more sense to wait until you have a higher income and are in need of a tax shelter?  When you start investing in your early years of work, your income is low and your tax burden is small – especially with tax deductions from your kids and mortgage interest.  Your largest income will be when you are in your 40’s and 50’s. That’s when you will need a tax shelter and will likely save the most money by investing in your 401k. 

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Reader Comments

Comment 1
MoneyEnergy Says: on Tuesday, August 05, 2008 11:18:08 AM

Good to see someone challenging the status quo. These are some good points and perspectives for looking at the issue. But I wonder, what you mean by "saving for retirement before getting out of debt is a foolish idea - even with a company match - that will likely be gone by the time you take the money out anyway." What exactly will be gone anyway by the time you take $ out?

I do like the idea of just trying to get oneself out of debt sooner.


Comment 2
Andy Says: on Tuesday, August 05, 2008 1:00:11 PM

A good contrarian view and I definetly agree you should get out of your bad debts first. Still, the 401K is one of the most effective long term investments (A Roth 401K is even better, but you are limited in contributions). The same logic you apply to 401K investing drawbacks could be taken to any other long term investing. So the tax benefits make the 401K a relatively better long term choice, unless you don't want to invest for the long term.

I also agree you should build up an emergency fund first.


Comment 3
Curt Says: on Tuesday, August 05, 2008 5:00:34 PM

@MoneyEnergy - What I mean by "saving for retirement before getting out of debt is a foolish idea - even with a company match - that will likely be gone by the time you take the money out anyway" is to say that it is unlikely that your money will maintain its purchasing power as inflation, higher taxes and fees consume a large part. If you need to borrow against it because you don’t have a savings account, then fees and interest will consume even more.

@Andy – Not so. The drawbacks to investing in a 401k plan are not the same as investing is other long term investments, because other long term investments provide more benefits and freedoms like increased cash-flow. I paid off my college loans ten years ago and it was the best long-term investment that I’ve made, because of the increase in cash-flow that I have enjoyed. Investing in debt reduction is just as much of a long term investment as anything else.

If you are in debt, which most everyone is, then investing in a 401k is more risky then paying off debts. Yet, 50% of Americans’ are invested in a 401k.


Comment 4
hank Says: on Tuesday, August 05, 2008 5:51:52 PM

Also agree with the unique angle on it; not so much the basis though. I think, like everything it has its place. Investing in general is risky, that's why it can make or break you. A 401k isn't my first choice of investment, but it certainly is a good viable one when you mix it with your other investing options; just don't make it your ONLY option and you're going to be alright...

Comment 5
qes Says: on Tuesday, August 05, 2008 8:57:38 PM

Well, what if someone has no debt? Is it alright then to invest in a 401k? I thought this article would tackle more than it did. Right now many people I know are irritated with 401k's because of the bailout being given to the financial sector. It's exposing the real problems with the market. What we're seeing is the fact that the market isn't free. Why give money to the financial powerhouses that are begging bernanke and begged greenspan to lower interest rates and artificially inflate the market. I don't want to put my money into the pockets of those people. 401k's would be in real trouble if people would yank their money out of the stock and bond funds and demand responsible policies from the market and our government.

Comment 6
Curt Says: on Tuesday, August 05, 2008 11:26:21 PM

@hank - My point is that people shouldn't be investing in a 401k plan (the stock market) until you have paid off their debts - and at that point, there are much better investment options without the limitations of a 401k plan. I'm not saying that people should yank their money out, but that they shouldn't be putting it in - in the first place.

@qes - That's exactly what I'm saying. 401k's are a money trap. The government can (and will) inflate the currency by bailing out and borrowing until your money is worth less then when you started.


Comment 7
Kyle Says: on Wednesday, August 06, 2008 9:50:59 AM

I agree that it's unwise to invest when you have mountains of high-interest debt. If you are paying 12% on a credit card by all means pay it off. You aren't going to earn that in the market. Once you are debt-free or at least have only low-interest, tax-deductible debt such as a mortgage, you can begin to invest. But it's best not to put all your eggs in the 401k basket. Since nobody knows what tax rates will be in 30 years, I invest both a 401k and a Roth IRA and also in taxable accounts and am looking to purchase some more real estate. The real estate and timber on it will (I hope) guard against inflation. 401k's have their place, but I certainly agree with you that it shouldn't be the only place you invest.

Comment 8
Curt Says: on Wednesday, August 06, 2008 10:14:18 AM

@Kyle - That sounds like a good plan to me. Private business investing and real estate are great alternatives to investing in a 401k plan. 401k's have their place as an investment option, but investment options should be for investors, not debt ridden consumers. The 401k is an investment plan that is sold to debt ridden consumers with the highly successful 'free money' marketing campaign.

Comment 9
calathea Says: on Friday, August 15, 2008 6:47:01 PM

Definitely get out of debt and have a cash emergency fund before you invest in anything. Or if getting a bigger paycheck because you aren't contributing to a 401k is going to encourage you to spend more, the max out the 401k.

I've cut back my 401k investing to just enough to get the match after years of maxing it out. It was a difficult decision but here's why:

1) Wanted more control -- don't want to be limited to the investments in the plan. Some of the things I want to invest in (eg, inflation protected bond fund) are not available in the 401k.
2) Too difficult to figure out what the fees really are.
3) Want easy access to my money if I need it before old enough to access a 401k/IRA.
4) Want my investments in more than one investment firm "basket." My non-401k investments are with a different firm or directly in I Bonds, etc.

I think I am disciplined enough to save the money out of my pay. If not, and my spending creeps up, I will go back to the 401k max.


Comment 10
proletarian Says: on Saturday, August 23, 2008 5:37:30 PM

Many employers don't offer 401(k) plans, so this "encouragement" isn't very effective.

Comment 11
JJ Says: on Thursday, October 09, 2008 12:23:07 PM

So...what happen to people's 401K now? I understand that we should just out wait the down turn but it is worth it? I am a saver and I have a pension, assuming I remain in the field. So I am not sure if 401K is a good idea for me. I recall a saying that if you loose 10% of your investment this year, you need to make an additional 18% back the following year to just break even. Can someone verify this claim? I am not sure what is the math behind this claim.

Comment 12
Curt Says: on Thursday, October 09, 2008 1:11:14 PM

@JJ - The short answer is ... you are screwed.

Here is a little humor for you
http://www.youtube.com/watch?v=WjJWr3n2wFs


Comment 13
401k Victim Says: on Sunday, October 12, 2008 2:23:08 AM

After I had lost about 10%, I switched to bond fund.
My plan is go back to school next year, and cash out ALL money from my 401k. I know I will have to pay 10% penalty plus little tax, coz I will study full time and will have no income next year. I don't trust 401k crap/trap no more. God bless all 401k Victims!


Comment 16
Sergey Says: on Friday, May 29, 2009 8:00:58 PM

* Loss of opportunity for 30-40 years
~Opportunity for what?

* Inflation (the dollar lost 2/3 of its value just during the 70’s recession)
~Stock market follow inflation, so typically you will earn at least inflation rate.

* Taxes are likely to be higher when you withdraw your money
~Hard to say. When in retirement, you are likely to earn less so you are likely to be in lower tax bracket.

* False sense of security, which increases a tolerance for debt and promotes bad spending habits of living beyond ones means
~Hand-waving

* Many plans are littered with hidden fees
~Agree

* Loss of control with limited investment choices
~Contradicts your next point

* Stock markets are risky and shouldn’t be invested in without a financial education
~Contradicts with previous point

My strategy for 401K.
-Invest now and get company match + less tax.
-When I decide to open business, borrow against 401K. Leave some for Taxes in cases it falls through. Also set aside some money for paying back to yourself to avoid taxation.


Comment 17
Warren Says: on Thursday, June 04, 2009 8:56:39 PM

I hate 401k's & 403b's ....hypothetical example... over 30 to 40 years you contribute 200k, your employer puts in 60k which equals 260k in TOTAL contributions. You would have deferred around 75k in taxes. Now lets say at retirement your 401k/403b is worth 10x what was put in, i.e. $2.6 million. Given a 20% tax bracket @ retirement, on lets say 150k year, how long will it be before ALL the taxes you deferred have been paid back??
Typically, the taxes you avoided will be TOTALLY repaid within 5 years, yet you will continue to pay taxes on your distributions LONG after you have repaid the govt their money!!
Assuming 30k annually going to taxes, within 2 1/2 years, you will have paid ALL the postponed taxes back. However.....
For the REST of your life, you will pay 30k in taxes to Uncle Sam!! Dont get me wrong, i know we have to pay taxes, but THAT MUCH??? I dont think so!
Think long and hard about your decision, it could VERY costly!!
Another thing to consider about a 401k/403b, they are subject to market fluctuations, which assuming a 30 year Bull market, you'll do fairly well, but that has NEVER happened! It goes up AND down, so very often, great gains will be wiped out by Bear markets!!
Every 'Advisor' out there seems to love these vehicles, and so they have rammed this idea down everyone's throat for 40years now. Just remember, however, popular concensus or opinion isn't always the wisest course, just ask Christopher Columbus!
Dont fret over this however, there is a much safer, totally liquid and TAX FREE alternative!
Shoot me an email and i'll share it w/ you!!!
NO JOKE, NO SCAM, NO KIDDING


Comment 18
Sergio Poza Says: on Saturday, September 26, 2009 6:13:00 PM

401K are badd! and yes infact its a good idea to start investing in a early age,,But not in a 401k!

Look into something else! GUL,EIUL,something more better ,TAX FREE! (WORLD FINANCIAL GROUP)HAS THOSE CHOISES....Term,Life its up too you!


Comment 20
Justin T Says: on Saturday, January 09, 2010 11:28:31 AM

Hey Warren,

Could you shoot me an email please, I want to learn more about investments please! Justni@aim.com


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