Are 401k plans still an efficient way to save for retirement?
In a nutshell, yes.
A controversial post by Aaron Brown titled “401(k) Plans No Longer Make Much Sense for Savers” recently raised the question.
While I believe that Mr. Brown makes some good points, I disagree that 401k plans are no longer effective. I believe just the opposite — 401k plans are more relevant than ever. Here’s why.
Tax advantages: Coming soon
Mr. Brown rightly points out that the current tax environment is much different from what existed when 401k plans were created back in 1974 and, as a result, the tax advantages of 401k plans have been greatly diminished.
True, but just wait a few years.
Given all of the economic stimulus that we are experiencing (which many people seem to be unaware that we, as taxpayers, will need to pay for) and the likelihood of a change in the White House (candidate Joe Biden has already promised that he will raise taxes), federal tax rates have nowhere to go but up, for a long time.
In addition, it is nice to be able to finance large federal deficit spending at near zero interest rates — which is happening now — but don’t bank on rates staying this low forever. When they rise, so will the need for additional taxes.
State governments are also finding themselves in fiscal trouble as a result of COVID-19. Many have cut their budgets as much as possible. Where will they find the funds they need to balance their budgets? I’ll give you one guess: you and me – the taxpayers.
Although the tax benefits of making 401k contributions are not as significant right now as in the past, you can be assured that very soon you will be able to realize meaningfully more value from making them.
Low cost: 401k plans cheaper for most
Mr. Brown makes the point that zero-cost index funds make it possible for retail investors (those investing in their own accounts outside of 401k plans) to invest at a lower cost than investors in 401k plans. And as long as you are investing on your own without the assistance of a financial advisor, that is true.
However, if you are like the vast majority of investors, you will need to hire a financial advisor to help you. Generally, advisory fees on small accounts (those under $1 million), are about 1%. The majority of 401k account holders have balances less than $1 million and, if they decided to roll their money into an IRA, would end up paying these fees.
The average cost of a mutual fund (which 401k plans use as investment options) is around 50 to 60 basis points (.50% to .60%). That is about half the cost of what investors would experience working with an advisor. Yes, there are other costs of administration that 401k plan participants may end up paying, but rarely would they exceed another 7 basis points (.07%).
Also keep in mind that the average 401k plan using an all index fund lineup (at Vanguard, for example) costs around 20 basis points (.20%). That includes all investment costs, recordkeeping, trustee and custody services. This is much less than the 100 basis points (1%) retail investors pay when working with an advisor.
So the cost savings that most 401k investors experience by keeping their money in their 401k plan and consulting with the advisor who works with the plan if they need advice is around 33 to 80 basis points (.33% to .80%).
The average 401k participant is getting a great deal relative to investment fees in a 401k plan – one that most could not replicate working with an advisor to a rollover IRA.
IRA rollovers: A bad idea
Mr. Brown is an advocate for allowing 401k account holders to roll their balances into IRAs at any time. I believe he feels this will lower costs.
Rolling a 401k balance over to an IRA is a terrible idea for the average American worker. In this post I have outlined 12 reasons why. Below I have highlighted just a few:
Most Americans have 401k account balances below $1 million and will end up incurring a 1% or greater financial advisor fee in an IRA rollover account. 401k investors typically don’t pay anything for help allocating their account balances in 401k plans.
Investors in IRAs are unable to access the cheapest institutional mutual fund share classes and instead end up owning retail share classes, which are much more expensive.
There is much less fiduciary protection for an investor in an IRA rollover brokerage account than there is in a 401k plan account.
IRA account holders also experience less legal protection in the event of lawsuits or bankruptcy in comparison with 401k account holders.
And on and on.
Tax-free withdrawals: Already available
Mr. Brown outlines some compelling tax reduction proposals for savers and also advocates tax-free withdrawals. The good news is that tax-free withdrawals are already available.
Most 401k plans allow participants to make after-tax contributions into Roth 401k accounts. If the account has been in existence for at least five years, account holders may take distributions at retirement of contributions and earnings that are state and federal tax-free.
In addition, those individuals able to contribute to health savings accounts (HSAs) make contributions that escape state, federal and FICA taxation. When balances are withdrawn during retirement to pay health care expenses, contributions and earnings receive tax-free treatment.
Want to give American workers an even better shot at a secure retirement? Allow all workers to fund their retiree health care expenses by making HSA contributions.
Unfortunately, Mr. Brown’s proposal to exclude 401k contributions from FICA taxation would weaken the funded status of Social Security, jeopardizing future retirees’ Social Security benefits.
401k plans are still a great place for workers to save for their retirement. Of the many ways to fund retirements, they remain one of the most effective and secure.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or email@example.com.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or firstname.lastname@example.org or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.