Young Savers: Ignore This REALLY Bad 401(k) Savings Advice
By Jeffrey Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
Let’s be frank for a moment. There’s an awful lot of retirement-related information available on the internet and through various other media outlets (which probably makes this a good time to thank you for choosing to get some of your critical info here at The Slott Report). And with so much content being generated each and every day, there are bound to be a few mistakes here or there. That’s understandable. Mistakes happen, and I’d be lying if I said I’d never made one myself.
There’s a big difference, though, between a simple error and a consistent stream of severely flawed advice, which brings me to the point of this article. A few weeks ago, I was forwarded this video via Twitter (follow me there at @IRAGuru4EdSlott), in which noted blogger, author, entrepreneur and hedge fund manager James Altucher strongly urged young savers to avoid making contributions to 401(k) plans. Now I have a great deal of respect for Mr. Altucher in many ways, but in my opinion this advice is comically misguided. After beginning his video by saying, “I honestly think you should take your money out of 401(k)s,” Altucher goes on to provide a number of reasons to support his position, most of which are egregiously flawed.
It’s hard enough to get young people to save for their retirement without exposing them to this type of misinformation. So, in an effort to help set the record straight, here are some of Mr. Altucher’s reasons to avoid contributing to a 401(k), along with why I feel they are incredibly misguided.
“This is what is actually happening in a 401(k)… You have no idea what’s happening to your money.”
There’s no question that despite recent efforts, transparency can be increased for 401(k)s and other employer plans in a number of areas. That said, to say someone has “no idea” what is happening to their money when it goes into a 401(k) seems like, at best, an exaggeration, and at worst, an intentionally deceptive and potentially damaging comment.
To be blunt, if you have “no idea” what’s happening to your money in your 401(k), you really have no one to blame but yourself. Even if you’re not a financial wiz, by simply keeping up-to-date with your account statements from one period to the next, you’ll usually have a pretty good idea as to what’s happening to your money.
“And by the way, if you want that money back before the age of 65, which is 45 years from now, you have to pay a huge penalty.”
Ummm… no! That’s not right at all! While it’s true that, in general, there is a 10% penalty (whether or not this qualifies as “huge” is debatable) for taking what’s known as an early distribution from a retirement plan, including a 401(k), the early distribution penalty doesn’t apply to distributions taken after 59 ½ – not 65. Plus, if you happen to retire or otherwise leave an employer in the year you turn 55 or later, there is no 10% penalty assessed on distributions taken from the plan sponsored by that company.
“They’re doing whatever they want with your money. They’re investing it wherever they want.”
About the only truth to this statement is that many 401(k)s offer participants a pre-selected menu of, perhaps, a dozen or so investment options to which they may allocate their plan funds. That said, you are generally free to allocate your funds to those selected options in any manner you see fit. Furthermore, if you decide a change in investment options is in your best interest, you can generally change your allocation when you see fit, and all without ever worrying about incurring any capital gains tax consequences, thanks to the protective “wrapper” provided by your 401(k).
Finally, it should be noted that the trustees of a 401(k) plan generally have a fiduciary obligation to regularly review the investments offered by the plan to make sure they are in the participant’s best interest.
“I mean the average 401(k) – they won’t tell you this – probably returns like… one half percent per year.”
There’s a reason that “they” aren’t telling you this (just who are “they” anyway?); because it’s a completely ridiculous statement. First of all, I have a huge problem with the way Mr. Altucher just casually throws out his one half of a percent (0.5%) statistic as if it doesn’t matter. His video was posted to a (very) reputable website, so it would be entirely reasonable for someone without a sound financial background to see the video and just accept the 0.5% statistic as fact. I respectfully challenge Mr. Altucher to back his statistic up with any kind of study, report or similar basis, but I won’t be holding my breath.
But let’s take investments out of the picture altogether. Many employers offer matching contributions; that is to say, they will make a contribution to your 401(k) account if you make one of your own. These matches are frequently made on either a dollar-for-dollar or 50% basis, up to a specified amount. Let’s take the 50% match – the less favorable of these possibilities – and use it as the basis for the following example:
Suppose that if you contribute $1,000 to your 401(k), your employer will make a 50% matching contribution of $500. That’s like making an instant 50% return on your money. Unfortunately, as I wrote last month, a tragically high number of people give up this “free” money. Bottom line, if you’re going to walk away from an instant 50% return on your money, you need to have a pretty compelling reason to do so. To make a comparison using Mr. Altucher’s 0.5% hypothetical return, it would take you just over 81 years to grow $1,000 to $1,500 if it was compounded at 0.5%.
“When you’re in your 20s, what does tax deferred even mean?”
So correct me if I’m wrong Mr. Altucher. You’re suggesting that there’s not much of a benefit to contributing to a 401(k) in your 20s!? For starters, there’s little doubt that establishing good savings habits at a young age translates to better savings habits during later stages of life. But even if we ignore the behavioral finance aspects of this misguided comment, the math simply cannot be cast aside. Contributing to a retirement account in your 20s (or as early as possible) can have a profound impact on your ability to successfully accumulate enough assets to retire comfortably.
To drive home this point, consider the following three scenarios:
In our first scenario, you contribute $5,000 to a 401(k) every year from the time you are 20 until you reach 29, bringing your total 401(k) contributions to $50,000. Assuming you earn 7% annually during that time, you would have about $69,000 in your 401(k) by the time you are 30. If you never contributed another dollar to your 401(k) but continued to earn 7% per year, by the time you reached 65 you would have close to $740,000 in your plan.
In our second scenario – perhaps after listening to Altucher’s video – you decide not to contribute to your 401(k) until you are 30 (instead of 20). From 30 until 39, you contribute $5,000 per year to your 401(k), for total contributions of $50,000 – the same as in our first scenario. Similarly, let’s say you have earned 7% annually during that time and, therefore, have about $69,000 in your 401(k) by the time you are 40. If you never contributed another dollar to your 401(k) but continued to earn 7% per year, by the time you reach 65 you would have about $375,000 in your plan. Thus, although you have contributed the same $50,000 to your 401(k) as you did in our first scenario, by waiting an extra 10 years to make those contributions, you have reduced your accumulated retirement savings by about half.
Finally, in our third scenario, you once again wait until you’re 30 years old to begin making contributions, but this time, in order to “make up” for waiting to make your contributions, you contribute $5,000 annually for 20 years, until you turn 49. That’s twice as long as in either of our first two scenarios. Here, assuming you earn the same 7% annually, by the time you turn 50 you would have about $205,000 in your 401(k). If no further contributions were made, but you continued to earn 7% per year, by the time you reached 65 you would have $565,000. That’s better than in our second scenario, but nowhere near as good as the $740,000 accumulated in our first scenario, even though you contributed twice as much to the plan. Again, this difference can be attributed entirely to the 10-year delay in beginning to fund your retirement plan.
Looking at these three scenarios objectively, there should be little doubt that contributing to a retirement account in your 20s can pay significant dividends. Of course, not everyone is lucky enough to do so, but discouraging those who are doesn’t seem to make any sense.
Update: Thankfully, since Mr. Altucher’s video was released, there have been other financial experts and journalists who have seen the errors of his advice and have helped to set the record straight.
For instance, here’s what Jack Otter, Editor of Barron’s.com had to say about Altucher’s video. Chances are you’ll note the similarities in our positions.