Personal Finance

Does a 401(k) Make Sense, or Should I Invest Those Funds Elsewhere?

Expertise: Business Management, Landlording & Rental Properties, Personal Finance, Personal Development
65 Articles Written
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I’m sure you’ve thought about whether or not your 401(k) is a good investment vehicle to utilize. If you are like most people, you may have trouble quantifying the total returns so you religiously contribute money on a bi-weekly/monthly basis, but feel like you are investing blindly.

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Growing up I was lucky to have parents and family who openly talked about finances. Although 401(k)s were often discussed, I was too young to fully wrap my head around the concept. Once I became a CPA and began taking on individual clients, I began to notice two trends: (1) 401(k) balances are relatively low compared to what I was told they were supposed to be at various ages and (2) people who are investing in their 401(k)s often cannot tell me whether or not it has been a good investment vehicle for them, even if they have been utilizing a 401(k) for years.

It turns out my clients and family members weren’t far from the norm of Americans. The average 401(k) balance has been increasing year over year. This is mainly due to the market’s returns over the past few years and larger contributions from employers and employees contributing to 401(k). Additionally, around 55 million workers were actively participating in 401(k) plans as of 2016. So plenty people are participating in their 401(k) plans.

Fidelity suggests the average worker has saved 8x their salary by the time they retire, yet a study done on 401(k) balances for the typical middle class worker found that pre-retirees, those aged 55-65, had an average balance of only $100,000 saved. If your ending salary is $90,000, your 401(k) should have $720,000 based on Fidelity’s general rule. Your 401(k) balance, based on the 4 percent rule, provides you with $28,800 in withdrawals each year in retirement.

Related: You Should NOT Bank on Your 401k For Retirement. Here’s the Superior Alternative.

Why the big discrepancy? I think there are many reasons; however, I am going to discuss the two that I believe to be among the most critical: failure to rebalance and high fees. I’m also going to attempt to quantify the 401(k) investment vehicle as a whole and show you what the typical 401(k) must earn in order to make the contributions worthwhile, rather than simply forgoing the 401(k) and investing that money in the market.

Failing to Rebalance Your 401(k) Will Sink You

It blows my mind how many people invest in 401(k)s blindly. By that I mean they don’t really understand what they are buying with their money, they don’t understand how the funds operate, they typically don’t know the 401(k) rules, and they certainly don’t rebalance their portfolio. In fact, only 15 percent of 401(k) participants rebalanced their 401(k) in 2014. This statistic alone shows me that many people truly “invest and forget” with their 401(k)s. Do you think financial advisors/money managers rebalance their client’s portfolios every year? You bet they do. And if they don’t, they have a really good reason not to.

The problem here is that 401(k) participants aren’t adapting their portfolios to new market trends. The argument can be made that personal investors tend to do worse than the market as a whole, as they make poor, emotional decisions – in fact, in 30 years, the average investor has returned a measly 1.9 percent. But does this mean the plan participant should never rebalance their portfolio? Absolutely not.

A 401(k) is not something to “set and forget,” as your returns will drastically suffer. By not rebalancing your portfolio, you become overexposed to certain asset classes. Maybe you are a 25-year-old and overweight in bonds, which slows your portfolio’s growth. Or you are 65 and overexposed to equities or emerging markets because you haven’t rebalanced in years and the next market crash wipes you out.

You should rebalance at least once per year. Make it a New Year’s activity. Read about the market and events that are expected to occur in the next year. Use retirement calculators and asset allocation calculators to determine your ideal asset allocations. Pay a financial advisor $80 for an hour of his/her time and have them review your 401(k) balances. It will be worth it in the end.

Young Asian businesswoman frowning with concern as she tries to understand something she is reading on her laptop computer scratching her head with her pencil in perplexity

401(k) Plan Participants Don’t Understand Fees               

There are typically high fees involved with 401(k) plans. The employer is required by law to shop around in order to get the lowest fees for their employees, but at the end of the day, the employer has the luxury of passing the plan fees on to the employees.

Fees range from plan administration (usually low) to fund management (usually high). The fund management fees are what plan participants can and should zero in on. Even though the participant has a limited selection option of funds to invest in, the participants can still pick funds with lower fees involved. Ideally, the participant would not invest in a fund charging more than 0.1 percent on assets. Sadly, I see many people paying 1 percent or more on investable assets, and those are only the front end fees.

Be sure to look at each of your plan’s fund choices carefully. Sometimes funds will have posted large returns in years past, but will charge an exorbitant fee. Be careful investing in these funds, as historic performance is not an indicator of future success, but the fees are for certain.

What Does the Typical 401(k) Plan Need to Return to Make it Worthwhile?

The big question is: Should I invest in my 401(k) or use the post-tax funds to invest in the market or alternative asset classes, such as real estate? The answer is quite complicated, as there are many variables involved.

My modeling was based on the assumption that tax brackets will never change, which of course is laughable. But it’s all I have to go on since literally no one can predict the tax or political environment in 30 years. So take my model with a big grain of salt.

Using the model I have uploaded into the BiggerPockets Fileplace, I have assumed that the average 401(k) return is 6 percent and that the geometric mean of the market since 1965 is 9.84 percent. I have two scenarios: the 401(k) contribution scenario and the non-401(k) scenario, which assumes that you have forgone the contribution and instead invested the post-tax money in a low cost index fund. My model only looks at the money you contribute or forgo to contribute.

Assuming a starting salary of $60,000, an annual raise of 5 percent, an annual contribution of 6 percent and a 50 percent employer match, at the end of 30 years, the 401(k) will have a higher balance than the “non-401(k)” option: $767,636 vs. $670,532, respectively. At 30 years I assumed we retire and begin withdrawing 4 percent for each scenario. After an additional 20 years (at the end of 50 total years), the 401(k) ending balance is $1,088,172, while the “non-401(k)” ending balance is $1,936,667. The big eye opener was that the 401(k) will generally outperform your post-tax money until you retire and no longer receive employer contributions. At that point, the “non-401(k)” portfolio drastically outperforms the 401(k) portfolio.

I also found that taxes are a moot point. Assuming a 4 percent withdrawal rate in both scenarios, the tax rate will be the same (15 percent) until the 401(k) withdrawals push the owner into the 25 percent tax bracket, as you will be paying 15 percent on the “non-401(k)” gains in the form of capital gains. Total taxes paid are going to be higher for the “non-401(k)” scenario, but the portfolio ends up with a significantly higher value than the 401(k) portfolio, which effectively makes the tax argument invalid.

Related: 7 Things to Do NOW to Get Your Financial House in Order

The good news is that I found if your 401(k) earns only 7.72 percent annually, assuming all the variables above, your 401(k) portfolio will have value equal to the “non-401(k)” scenario at the end of 50 years. This means that the answer to the “should I invest in my 401(k) or not” question comes in the form of another question: Will your money earn at least 7.72 percent annually in your 401(k), and if not, will you invest your post-tax foregone contribution, and will that money earn 9.84 percent annually?

401(k) pic 1

401(k) pic 2

What Am I Doing?

An employer match is a big component of a successful 401(k) plan, and unfortunately, my employer will only match 25 percent up to 6 percent. Because of this, I have decided not to participate in my employer’s 401(k). I’m sure it may make sense in the future, but I need to earn more and see a higher employer match first.

One thing I didn’t mention in this article was solo-401(k)s for self-employed individuals and business owners. Due to the significantly higher contribution limits for solo-401(k)s, I can’t think of a time where it wouldn’t make sense to max out this investment option, financially speaking.

Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.

What do you think of investing in a 401(k)? Would you ever invest your funds in one, and if not, what’s your vehicle of choice?

Let’s talk in the comments section below.

Brandon Hall is a CPA and owner of The Real Estate CPA. Brandon assists investors with Tax Strategy through customized planning and
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    John Murray from Portland, Oregon
    Replied over 3 years ago
    All investments are about paying the least amount of taxes and getting the maximum gain. The idea of tax deferment is to pay the tax when it benefits the individual. With defined benefit plans being almost eliminated from the working people in the US, some other means by the IRS were installed. Deferred Compensation for the public sector and 401K for the private sector are the only 2 choices workers have. Social Security is the last of the great defined benefit plans that most US workers will ever see. The individual must decide how to invest and how to pay the minimum tax. Unfortunately most people in the US do not pay attention to what their money is doing.
    Keith Weinhold from Anchorage, Alaska
    Replied over 3 years ago
    I sure haven’t read every comment. But it seems like a lot of people miss the big picture with 401(k)s: They are Salary Reduction Plans. Instead, choose a Salary Increase Plan. When 401(k)s were first rolled out, they even were ominously called “Salary Reduction Plans”! To encourage participation, they scrapped the name. Salary reduction is still what 401(k)s principally do to you. Instead, by investing your funds into cash-flowing real estate, you’ve selected a “Salary Increase Plan”. Now you’ve increased your income in young age, middle age, and old age, and still receive tax benefit. 401(k)s aren’t tax-deferral plans so much as they are life-deferral plans. People take a magnifying glass to 401(k) by looking for things like: 12b-1 fees, weighing fund selections, tinkering with asset allocation, and more. But that’s all of minor impact to your life. Don’t give yourself a pay cut. Give yourself a raise by buying cash-flowing assets. Why “delay gratification” if there’s no benefit in the delay?
    Nate
    Replied over 3 years ago
    Exactly! That’s my point. Why wait 20+ years to start earning retirement income? Why not accelerate the process of building passive income and do it in less time?
    Jonathan Henley from Tampa, FL
    Replied almost 3 years ago
    I have been struggling with this a lot lately. I am new to SFR investing but have begun a portfolio this year. My company has a very generous 401(k) matching policy: they provide a 50% match of all my contributions, right up to the legal limit. I am not currently maxing out my 401(k) contributions, and I am unsure if I should use funds to purchase SFRs that could otherwise be going into the 401(k) with the 50% match. It seems to me that a great return on real estate would be in the 25%-35% range (for COC), which is handily beaten by my employer’s match. Am I right in thinking that I should get to where I can max out my contributions before purchasing more properties?
    Nate Reed Real Estate Investor from Austin, TX
    Replied almost 3 years ago
    “It seems to me that a great return on real estate would be in the 25%-35% range (for COC), which is handily beaten by my employer’s match.” Do the IRR calculation on your 401(k) with employer match vs. the ROI on a property over a longer period of time. I think you will be surprised. The longer the timeframe, the less impactful the match that occurs in the first year. Also, take into account taxes. You will have to pay taxes on 401k distributions. Rental property done right should have no taxable income and capital gains can be deferred indefinitely through 1031 exchanges. Getting the employer match is good, just understand what you’re giving up.
    Derin White from Bremerton, Washington
    Replied almost 3 years ago
    What doesn’t make sense is comparing a tax treatment (401k) with an asset class (equities). Apples and oranges.
    Susan Maneck Investor from Jackson, Mississippi
    Replied about 1 year ago
    Unfortunately people who are unable to manage their 401K investments well are not likely to do well with other investments either such as real estate. What makes sense is investing in a 401K up to the match and then finding some other investment vehicle. By the way, I don't think it makes sense to compare what the average pre-retiree has invested to what someone who makes 90K should have invested. The folks with only 100K in their 401K are not the ones making 90K a year.
    Howard L.
    Replied about 1 year ago
    This seems to be a copy of an article posted years ago. Quite a few issues with the analysis raised and discussed in the four year old comments. And how many people that retire actually keep their assets in their 401k? I would expect that most roll it over into an IRA and thus the fees issue disappears. 1. Free money is free money. Advising people not to take the employer match would be bad advice. What happens to that money once it is in the account is a separate analysis and depends on so many different personal factors and plan choices, that it's not really worth discussing except on an individual level. Did you analyze the 401k v. "non-401k" where the investment in both accounts was a low cost index fund? Did you compare fees between a taxable account and a rollover IRA account? 2. Whether investing in a 401k beyond the match makes sense depends on your federal tax bracket and your state income tax rules. 3. The purpose of the employer match is to encourage people to save for retirement. If there was no employer match, many people wouldn't save at all. 4. How many people do you know that work the same job for their entire career? Most in this new economy change jobs frequently, whether by choice or not. Whenever you change jobs, you can roll the 401K into an IRA, which allows you to invest in whatever you want with tax-free growth, and low fees. Again, the value of the tax-free growth depends on your fed tax bracket, your state income taxes, and how you invest it. 5. What about a Roth 401k, now offered by many plans? 6. The article acknowledges that rebalancing is important. Whenever you rebalance in a taxable account, its going to cost you in taxes at the capital gains rate. Whenever you rebalance in a 401k or rollover IRA, it does not. That may be a HUGE difference over time, if you rebalance each year. 7. As Susan correctly points out, there is no guarantee of returns in real estate or other alternative investment vehicles. 8. The one significant negative of all retirement accounts, which apparently no one has addressed (didn't read every comment) is that when you have losses in a non-taxable retirement account, you get no benefit of offsetting gains or offsetting earned income ($3000 a year). Growing tax free is great if you actually grow. But if you end up losing, its better to be in a taxable account.
    Jeffrey Bower
    Replied about 1 year ago
    "Failing to Rebalance Your 401(k) Will Sink You" Wow, didn't know this. I should get that done. Thanks!
    Eka Linwood Rental Property Investor from Overland Park, KS
    Replied 8 months ago
    You cited the following article: https://www.interest.com/savings/401k/kind-return-expect-401k-plans/ as the basis for the 6% assumption. The quote I found was from Mari Adam (Adam Financial Associates) "I think 6% is a reasonable expectation for retirement planning purposes if you’re investing properly for your age", so this is an assumption. A big assumption, I think. The same article has also mentioned 5-year average return for VINIX (Large Blended) as 10.89%, and VBTLX (Bond) at 3.14%. Even if you diversify into large cap and bond @ 50:50, you'll get an average return of about 7%, so the 6% assumption that Mari Adam has mentioned is obviously that - an assumption. If you increase the return assumption from 6% to 7% in your 401k calculation, I am fairly certain you'll see return from the 401k match be the better option. The average 9.84% stock gains that you have cited here: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html is simply that - average stock gains. It is an index. VINIX is an index. VINIX management fee is 0.035%: https://investor.vanguard.com/mutual-funds/profile/fees/vinix In order to make a 25% company match "not worth the investment", the management fee / spread needs to be less than 25%. Let's assume that the 6% annual return rate is true for a certain investment vehicle. This investment vehicle would need to charge you 1.5% of management fee, for your company match to break-even. If they are charging you 2%, you're losing money by investing through this investment vehicle and should invest it yourself instead. If you assume 8%, this spread needs to be 2% instead. 10% requires 2.5% spread. As we have looked at just now, VINIX is 0.035% with 10.89% - if the company matches your contribution at a rate of 1%, you will still do better if you invest and get a company match. This hasn't even taken into account the tax advantage of 401k. Comparing 401k to Real Estate is a totally different ball-game, since Real Estate is not what I would consider a "Passive" investment with a whole set of new risk profile. I'd urge that you would consider making this change into your article here as it looks like a lot of people are reading your article, and thinking their 401k match "isn't worth it". I understand that making this kind of statement attracts "clicks" and "reads" but being misleading is unethical.