Are 401(k)s overrated?

Lately, there has been a massive debate on Twitter/X. The good old 401(k) has come into question.

As with everything in personal finance, please take this piece with a grain of salt. This will be heavily generalized and will not be specific to anyone’s individual situation.

Now a lot of what I will be talking about has been covered by Nick Magguilli in his blog, Of Dollars and Data. Here is a link to his article.

First, I’ll make the case as to why I absolutely love 401(k)s:

1. They are the definition of “set it and forget it.” I have never seen someone adjust their contribution rate due to market fluctuations. Usually, people are able to remove their emotions from this account completely.

2. There is the potential for matching contributions from your employer. As I’ve said in previous pieces, this is about as close to a free lunch as you’ll ever get. One thing to note is the vesting schedule of these matching contributions. Sometimes, it can take a while for you to fully vest your matching contributions, aka, the money is not yours until some time has passed.

3. There is a tax-advantaged nature to 401(k)s. Whether you choose pre-tax or Roth, you are going to receive either an upfront tax advantage or a tax-free withdrawal come retirement. In either case, the account allows your money to grow tax-free. Essentially, you will not owe capital gains tax or taxes on any income/dividends while you are actively participating.

   1. ***Note: Nick does a great job explaining the extent to which the tax-advantaged nature of the account is advantageous. I highly encourage you to read his piece, his work is amazing.

Let me make this abundantly clear before I give some drawbacks to 401(k)s, I think that the advantage of a 401(k) lies in its automation… NOT its tax-advantaged nature. I have literally compared people’s investment account performance to their 401(k) performance and usually, their 401(k) performs better. In my experience, people are less likely to shift their allocation or adjust their contributions. They just allow the account to grow.

A lot of a 401(k)’s benefits lie in the fact that we are emotionally detached. The money is for wayyy down the line. I’m talking 30-40 years. If only people viewed all their investment accounts like that. But that is for another piece.

A lot of the drawbacks to 401(k)s are more prevalent for younger professionals, but that is who this newsletter is focused on so here we go:

1. I’m not going to say that your funds are locked up but they are not nearly as liquid as a brokerage account would be. Getting at them involves high-level planning techniques and there are still restrictions that are not associated with a brokerage account.

   1. Yes, I am aware of SEPP (Substantially Equal Periodic Payments), the Rule of 55, loans, and hardship withdrawals.

      1. I get it. There are tactics and strategies to get at your money. But even these tactics have limitations. You cannot make the argument that a 401(k) is more liquid than a standard brokerage account and that is the point I am making.

2. Specific to young professionals - There are so many things in your life that you will want to save for. A home, a renovation, a new car, etc. A 401(k) is not an avenue for any of those things, it is generally for funding retirement. Remember that!!

3. Plan fees and administrative expenses are a real thing. I have personally witnessed someone who had a 401(k) plan and every fund option had an expense ratio of over 1%. That is absolutely asinine and outside of attaining the employer match, is likely not worth it. ESPECIALLY when you consider Nick’s calculations and the math behind it. Some plans have very low-cost fund options, make sure you are aware of what your plan is offering and the cost of each fund!

That’s about it there, guys. We put a TON of value in flexibility, especially when it comes to young clients. Understanding your goals and time horizons can allow you to understand whether increasing your 401(k) contributions over the match makes sense.

When we work with clients, we always define goals and time horizons. For some people, it is a no-brainer to contribute the maximum to their 401(k). For others, sometimes it is just up to the match.

Each person’s financial situation is different. One “blanket statement” that I actually do agree with is, “Your 401(k) should not be the only account you are contributing to.”

A standard brokerage account is an amazing way to invest and know that the funds can be used at any time, with no restrictions or tricky tactics, and no penalties.

Not to mention, brokerage accounts have some favorable tax advantages themselves. Tax-loss harvesting and the preferential capital gains tax are huge! In 2024, a married couple filing jointly with taxable income below $94,051 will pay 0% on capital gains… That is pretty sweet.

It is never a bad idea to map out where you are saving, why you are saving, and to what extent you are saving. There is some optimization around where to save and the only thing it depends on is your goals and time horizons. Your financial life shouldn’t be governed by a rule of thumb.

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Have a more specific question or want to get your finances in order? Feel free to reach out to [email protected] for a free consultation!