Thinking about the 401(k) Account: Should I Have One? How Much Should I Contribute? What are the Risks? Trying to Interpret the Experts

Planning for retirement raises a number of difficult questions. I’ll admit that I often get confused coming up with answers. And I’m an economics graduate who started investing in high school and enjoys reading financial articles. I have sympathy for anyone that feels overwhelmed or confused by the experts.

I think the main problem is that experts tell you what to do without telling you why to do it. Cookie cutter advice fails with a task as individual as retirement planning. We need to separate fact from judgment, and that’s what I’ll try to do in this article.

I’ve reviewed many expert articles and summarized their answers and thinking below. I also provide a discussion about risks that is notably omitted in most articles.

Do not interpret this as financial advice. Please seek professional help when making decisions.

From what I gather, here is what experts say about the 401(k) account:

–Should I have one?

Yes, if affordable.

–How much should I contribute?

This point is debatable. A starting point is to get the employer match. From there, save more, possibly in a Roth IRA, taxable account, or by maxing out the 401(k) contribution. Some experts don’t think maxing out is a good idea.

–What are the risks?

There are three main risks:

• Money is harder to access
• Investment options are limited
• It’s hard to predict taxes or the future

Below, I provide more details on the answers and give references where applicable.

–Why should I have a 401(k) account?

The 401(k) account is a tax-advantaged way to save for retirement. Here are some articles about the perks:

• employers often match contributions (Milk Your Money, 401kcenter)
• money contributed is tax-deductible (Kiplinger)
• investments grow tax-deferred (Your Investment Advice)

These benefits make the 401(k) one of the most lucrative accounts to save for retirement.

The account is relatively easy to set up. At most companies, you can call the Human Resources department and tell them you want to enroll in the plan. If you are eligible and join, you then need to specify how much you want to contribute. That’s the topic of the next question.

–How much should I contribute?

How can you take advantage of a company 401(k)?

As a starting point, experts recommend contributing up to the company match if possible. That’s because the match is free money, which is hard to pass up.

Financially speaking, free company money essentially softens losses and magnifies gains to your contributions. If you get a 100% match, for example, you can lose an amazing 50% and still break even on what you put in—you’ve only lost the matching money. Alternately, even if your investments grew a measly 1%, you would still be up a whole 102% (you get 100% return from the match, plus 1% growth on your money and the match money).

So far, so good. Now the harder question: should you invest even more than the match?

Most experts and bloggers say yes, it’s good to maximize contributions in a 401(k) (see The Street, CNN Money, FreeMoneyFinance). The account has tax advantages and is one of the best ways to save since money is directly cut from company paychecks.

I think this is a judgment call. There are other places to save that could be much better. Rather than assume what people are disciplined to do, I’d rather know what’s right. And in that sense, I’m not convinced it’s the best thing to maximize 401(k) contributions. Two reasons weigh on my mind.

First, there are important risks to investing in a 401(k) that don’t get talked about frequently. Perhaps that’s why 25 percent of adults are withdrawing retirement funds prematurely, often incurring penalties. Some of the reasons are for medical expenses, vacations, or credit card debt. I wonder if these people could have been better off saving in a taxable account.

Second, even with tax advantages, it’s not clear maximizing a 401(k) yields the highest return. This is a very controversial topic. Two economists have run the numbers and discovered maximizing is not always the best decision. They conclude the average American should contribute to the company match, and then save in other places (like a Roth IRA or a taxable account). You can read about their conclusions in this BusinessWeek article. Here is my favorite quotation from the article:

“If we’re inducing people to save in 401(k)s on the basis of tax savings that aren’t there, that’s wrong”– Laurence J. Kotlikoff in BusinessWeek

The article mentions a software program called ESPlanner that is supposed to help with planning. It sounds exciting.

What are the risks of a 401(k) account?

All investment options come with risk, and the 401(k) is no exception. I tried researching this topic but was disappointed. It seems everyone is so caught up telling people to contribute the maximum amount that risk is only tangentially addressed. If they appear at all, these risks are written in tiny print or as a small hedge.

To come upon a solution, I talked to some very smart people. I talked to a financial adviser, an investment banker, and a hedge fund analyst and drummed up a list of risks for investing in a 401(k) account compared to a regular, taxable account.

1. Money is harder to access

In regular accounts, you can get your money pretty quickly. Just sell a stock or transfer money to a checking account and use it for whatever you wish. It’s easy.

This is not the case with a 401(k). There are restrictions on how you can withdraw the money since the account is really meant for saving for retirement. If you want your money earlier, there are ways but they are not always pleasant. You can borrow against the account or taking an early withdrawal. But these methods might have direct costs (processing fees, 10% penalty) and indirect costs (lost investment time).

2. Limited investment options

In regular accounts, you can generally invest in whatever you want. You can buy any publicly traded stock, or you can withdraw the money and invest in your friend’s private company—a real consideration for entrepreneurs.

In a 401(k), you are limited to what your company offers.

3. Tax issues

Retirement accounts derive many advantages from their tax treatment. In a standard 401(k), you don’t get taxed on contributions now but rather on distributions later. In between, the investments can grow tax-deferred. Shouldn’t a tax advantage mean a tax benefit?

No, not necessarily. The problem is that it’s very hard to predict future tax brackets. Will they go up or down? Which tax bracket will you be in when you need the money?

Here’s another example. If you contribute the maximum to a 401(k), and that lowers your current tax bracket, then you also reduce the value of the tax deduction on your mortgage interest payments.

The standard 401(k) delays paying taxes until withdrawal. There is a newer Roth 401(k) that does the opposite: you pay taxes now but none later. There is much debate about which option is best. Tax brackets aren’t a certainty.

In Conclusion

–The benefits of the 401(k) make it suitable for most people. If you don’t have one, it’s useful to evaluate why not.

–It’s a debatable issue about how much to contribute, but if possible, at least contribute to get the full company match.

–Keep the risks of a 401(k) in mind. You might elect to save in other ways even if they have harsher tax treatment.