Create your very own Auto Publish News/Blog Site and Earn Passive Income in Just 4 Easy Steps
When you think of financial fraud, you might think of Bernie Madoff and the Nigerian princes. But if you listen to enough “financial experts” on YouTube and TikTok, you might hear that the humble 401(k) is a scam.
A 401(k) is a tax-deferred retirement account offered by many employers. It's an account so simple that it may become a victim of its own success. Has the 401(k) cheated aspiring retirees out of their hard-earned money?
We don't think so, but we'll explain why the account is so heavily vilified.
What is a 401(k)?
A 401(k) is a tax-advantaged retirement account that employers offer to their employees. Many companies offer an employer match to employees who contribute to a 401(k). For example, a company may offer a 50% share of all contributions up to 6% of your salary. If you make $50,000 and deposit $3,000 into your account, the company will deposit an additional $1,500 into the account.
With a traditional 401(k) plan, the money you contribute is tax-deferred. This means you will receive a tax deduction for the money you contributed to the account. The money grows tax-free until you withdraw money in retirement. When you withdraw money, you pay ordinary income tax rates on your withdrawals.
More and more companies are now offering a Roth version of the 401(k). When you make Roth contributions, you pay taxes before you contribute to the account (no immediate tax break), but you never pay taxes on that money again. Your retirement withdrawals are tax-free.
As an employee, you can contribute up to $23,000 to your 401(k) account in 2024. Your employer can contribute up to $46,000 to your account (although this probably won't happen unless you earn very well or are self-employed).
The 401(k) is simply an account that stores money. But we will look at the reasons why some influencers call it a scam.
Related: 401(k) Contribution and Income Limits
What do the 401k scam videos actually say?
Here's an example of the videos you see on TikTok and other social media:
We'll highlight the main counterarguments below, but when you see these reports, you should also check to see if the WHO is discussing this issue. In the case above, this person is clearly a life insurance salesman and is promoting IULs on his account.
Why do IUL sellers attack your 401k or retirement plan? Because when you're young, there's competition for dollars – you typically don't have enough money to contribute to both a 401k (or another investment like an IRA) and the money needed to fund an IUL.
So these people are trying to scare you into thinking that you are doing something bad and that their product offering is better. But unfortunately we've never seen a real example where it actually performed better.
Remember: These companies are showing you “illustrations” and not actual policies. And none of them can show you a valid IUL that has been in place for over 10 years. They're incredibly rare for a reason: They don't work as advertised on most Americans.
Your money is locked away
Predictably, when influencers start attacking the 401(k) account, the first chance is that the account will “lock your money away.” While this doesn't mean the 401(k) is a scam, this claim is true. A 401(k) is a retirement account. For any money you withdraw from the account before age 59, you will pay a 10% penalty. So when you withdraw money from your 401(k) account, you pay income tax and the penalty for every dollar you withdraw.
A 401(k) is not an emergency fund and should not be used as one. If you believe you cannot keep the money in the account, you should not deposit it into the account in the first place.
Some companies allow you to take out a loan against your 401(k), but we recommend against it for several reasons. While you are borrowing, your money is not invested, so you lose time in the market. Additionally, if you leave your job, you'll likely have to repay the loan within 90 days (or sooner), otherwise you'll pay a 10% withdrawal penalty.
For comparison, most of the people who insist on keeping your money locked away are selling life insurance. You cannot “withdraw” money from life insurance. Instead, you take out a loan against the policy and pay it back over time. The money in the policy is almost as “locked in” as the money in a 401(k) plan.
401(k) fees eat into your returns
Many people who hate 401(k) plans point to excessive fees. This is a point that varies from plan to plan. Most large companies have low or no account maintenance fees (I can say my 401(k) account fee is $12 per year). Additionally, investment fees in 401(k) plans tend to be modest (investment fees between 0.1% and 0.3%).
But these maxims will not always apply. Smaller companies or those with outdated 401(k) plans may charge higher fees. If the only investment options within your company's 401(k) program have investment fees of 1.5% to 2.5%, you may want to reconsider before investing in them (at least above your company's level beyond). Even with high fees, you should invest enough to keep up with your business, otherwise you'll miss out on some of your compensation.
The 401(k) offers terrible investment opportunities
Investment options within 401(k) plans vary. The vast majority offer low-cost index funds or a handful of actively managed mutual funds. Some companies allow you to invest in individual stocks, but this is more the exception than the rule. Unless you have a self-directed 401(k), your investment options are typically quite limited. But that doesn't mean the investment opportunities are bad. The stock and bond funds available in most 401(k) plans allow you to maintain a well-diversified investment portfolio.
Most people who call a 401(k) a scam because of its investment options have a vested interest in getting you to invest in an esoteric or costly investment. You can promote leverage, high-fee private REITs, high-frequency trading, or life insurance. Many of these investments are good. You may benefit from some exposure to real estate, precious metals or other alternative investments. But you can get this exposure in addition to your 401(k), not instead of it.
Investing in alternative asset classes can give you higher returns, but that doesn't reduce the value of equity and bond funds. Most 401(k) plans offer simple, proven investment options that can help the average person build wealth over time. Alternative investments, particularly those that involve leverage (debt), are risky and could erode your wealth as easily as they could build it.
Your 401(k) keeps you stuck in your job
Some companies have vesting plans in their 401(k). A vesting plan means that an employee must stay with the company for a certain period of time before they can keep their employer's 401(k) contributions. A company may have a cliff vesting plan that requires employees to wait up to three years before taking ownership of the company's 401(k) contributions. Companies may also have a graduated vesting plan, in which you become the owner of a portion of the company's 401(k) contributions over a period of up to six years.
The vesting rules can be an incentive to stay with a company longer than usual, but they certainly do not restrict you in your job. Any money you contribute to a 401(k) account is your money and you can keep it if you change jobs. If you change jobs, you can put the money into either your new 401(k) account or an IRA.
You must pay taxes on your 401(k).
A traditional 401(k) contribution is a tax-deferred contribution. You don't pay taxes when you invest money, and you don't pay taxes on your investments as they grow. However, when you withdraw money, you pay your ordinary income tax rate.
Income tax rates are already higher than capital gains tax rates, and income tax rates could increase in the future. If you withdraw money from your 401(k) account in retirement, you may have to pay high tax rates on those withdrawals.
Given the historically low tax environment we currently find ourselves in, you should consider a Roth 401(k) option if it is available to you. If you use a Roth 401(k), you now pay income tax on the money. But the money will grow tax-free. And when you withdraw the money, you don't have to pay taxes on the withdrawals.
Many slippery salespeople will try to get you to buy life insurance by claiming it is more tax efficient than a 401(k). The value of a cash value life insurance policy actually increases without taxation. Additionally, when you pay out your life insurance policy, you only pay capital gains taxes, not income taxes. However, you won't get any tax relief if you pay money into life insurance. That means you pay income taxes before you pay for the life insurance, and you pay capital gains on growth when you cash out the policy.
The tax issue is complex. A fiduciary financial planner could help you figure out whether you should invest in a traditional or Roth 401(k). Either way, a financial planner with your best interests in mind will rarely recommend a life insurance product over a 401(k) contribution.
Should you invest in a 401(k)?
If your company offers a 401(k), please invest in your 401(k) at least until matched. You don't want to leave money on the table. Then follow the steps to save for retirement. A 401(k) is not a scam. It's a tax loophole that you can use to your advantage. With the 401(k) you can invest your money in a tax-efficient manner and thus increase your wealth in the long term.
Create your very own Auto Publish News/Blog Site and Earn Passive Income in Just 4 Easy Steps
