I’m going to start this blog post off with a quick story: I actually wrote this entire blog post in my favorite coffee shop only for something to go completely rogue and the entire thing got vanished into oblivion. I’m pretty sure my forehead slapped my keyboard as I internally screamed the F word.
I was writing it all in a Google Doc which consistently saves your work, so I have no idea how it got completely wiped clean. If a paragraph or two didn’t save, then I’d suck it up and rewrite it. But for some reason, the entire post left Earth and probably went through a black hole. I trust that things happen the way they’re supposed to, so I left the coffee shop and power walked the beach listening to deep house music.
Something similar happened to me in college. I had a ten page history paper due and the night before my laptop crashed. I wrote the entire paper and lost everything. So, I wrote an epic introduction paragraph followed by a single paragraph, printed it out 10x and submitted it as a 10 page paper. Pretty sure I either got an A- or a B+ which taught me that my professors didn’t read sh*t. Silver lining: I never wrote another ten page paper again for the rest of college and I passed with flying colors.
But I do want to write this blog post over again because many of you messaged me that you were curious about this topic of not maxing out my 401(k). So here it goes!
Is a 401(k) a scam?
For starters, I don’t think a 401(k) is a “scam” by any means. I’ve heard this statement made before, but I would not call it a scam. Here are some of the reasons I’ve heard that 401(k) is a scam:
“You have to wait until you’re 65 to cash it out.” This is false. It’s 59.5 and there are ways to access the funds before 59.5 without penalty via the Roth conversion ladder.
“A 10% withdrawal penalty is scammy." This would likely depend on the definition you have for “scam.” It’s just a rule of a retirement account, kind of like how some checking accounts charge you $10 per month. Is that a scam?
“Because you have to pay taxes.” I’m just going to let that one sit there. We all know Uncle Sam is relentless, but then again nearly 70,000 pages of the tax code teach you how to legally avoid paying taxes, whereas 5,000 of those pages tell you where to pay up.
“401(k)s with vesting periods are scams because they make it where it nearly forces the employee to stay with the company.” Sure, they may do it for retention, but it doesn’t make the retirement account a scam.
“If it has no employer match, it’s a scam.” I asked this person for an explanation and they commented saying “you’re locking your money in prison for 30+ years when you can contribute to a taxable brokerage account.” His response had nothing to do with the employer match and he may not understand how to get your money out before age 59.5 without a penalty, or how to invest optimally with other accounts to use before 59.5 without penalties *cough* taxable brokerage *cough*.
“A 401(k) with high fees is a scam.” I’m assuming this person defines anything with high fees as a scam. Not all 401(k) accounts have funds with high fees. Sure, a lot do, especially smaller companies. However, I’ve seen many people’s 401(k) accounts with very low fee options.
“It’s a scam because people make it seem like its necessary.” It’s not necessary but it’s a great investment vehicle for retirement. Should it be the only account you have to set yourself up for retirement? No.
One argument however is that the 401(k) is a monumental win for corporations to exit pensions and puts the responsibility of investing for retirement on the employees. I still don’t think it makes it a “scam” per se, however, I understand this viewpoint.
I still stand by the fact that a 401(k) is an important account to have for retirement, especially for people who wouldn’t invest on their own. If you don’t have the discipline to pull money from your paychecks to invest in the stock market, then a 401(k) can be incredibly practical and favorable. A percentage of your income (up to your choosing) would automatically be deducted from your paycheck and invested.
Alright, now let me get into why I never chose to max out my 401(k). I realize this might be shocking considering I talk about lowering your overall taxable income often, but there’s a big reason why it didn’t make sense for me. It has to do with math, of course.
Why I never maxed out my 401(k)…
For over ten years of my career, I’ve had access to contributing to a 401(k). And the first two years of those ten years, I had no idea what I was doing or what a 401(k) was, but my Mom always told me to contribute up to the company match, so I did (she’s always right).
One thing I recommend to everyone who has access to a 401(k) is to invest at least up to the company match (that is, if you are offered a match). For example, if the company you work for provides a 401(k) with a 3% company match, then I’d recommend contributing 3% of your income to your 401(k). By not doing this, you’re quite literally leaving free money on the table. In fact, you’re basically leaving part of your compensation on the table. You know the drill: Don’t leave free money behind.
But what about contributing more than the company match? It depends on fees.
The fees within my 401(k) were so stupid high it set my iMac on fire, made me dry heave, and obliterated my immune system. Not really, but I’m feeling a little dramatic today.
I’m going to teach you how to check your fees, because this actually really matters. When it comes to the PEMDAS of investing, I typically recommend this order:
Invest in your 401(k) up to the match
Max out your HSA (Health Savings Account): $3,600/year
Max our your Roth IRA: $6,000/yr or $7,000 if you are 50+
Invest back into your 401(k) up to the max: $20,500 for 2022.
Invest in a taxable brokerage account
Essentially step 4 takes the back seat if the fees of your 401(k) are as scandalous as mine were.
How to check the fees of your 401(k)
Calculating these fees takes about as much time as it does to brush your teeth, a few minutes. There are two different types of fees to calculate: administrative fees and investment fees.
Administrative fees are a bit more challenging to locate but I’ll help you out.
Investment fees are easier to find and are based on the actual funds that are purchased within your 401(k).
Side note: I’m going to just start typing 401k instead of 401(k) because the amount of parenthesis I’m typing out is really harshing my mellow.
Back to administrative fees… A 401k plan costs money to run, that’s of no surprise. These fees are typically your responsibility and can be found on your plan’s summary annual report. Money Crashers explains perfectly how to calculate these:
On your plan’s summary annual report, “you will need to find two numbers: total plan expenses and benefits paid. Subtract the benefits paid from the total plan expenses.
Next, you will divide that number by the total value of the plan. The resulting number is your plan’s administrative cost percentage. Multiply the percentage times the total value of your holdings within the plan to get the amount of administrative costs that you paid for during the year.”
The next fee to figure out is much easier. In fact, I’d start with this first and if you find that these fees are high, you may not even need to bother looking for the administrative fees.
In my 401(k) most of the funds I had options to invest in had a front load fee of 5.25% and an expense ratio of 1.75%. So…7% or 700 basis points. Ouch. (I used much more choice words than “ouch” when I saw the fees).
Normally points are what you want in things like video games, but when it comes to investing or borrowing money, the lower the points, the better.
This begs the question: “What should you do if you have high fees in your 401k?
And how many basis points is too many points where it makes sense to invest in a taxable brokerage account instead of maxing out a 401k? I’ve got some answers.
My friend, Nick Maggiulli, the blogger behind Of Dollars and Data, wrote an incredible blog post saying that “if the investment options in your employer’s 401(k) plan are just 0.73% more expensive than what you would pay in a taxable account, then the annual benefit of a Roth 401(k) is completely eliminated.”
Nick’s data used a comparison of a $10,000 annual investment into a Roth 401(k) versus $10,000 in a taxable brokerage account over a 30 year time horizon. He assumed the same interest per year and that with the taxable brokerage account you would need to pay long term capital gains rate of 15% on a 2% annual dividend (and the same investment options).
He did a fair comparison for the Traditional 401k where he increased the contributions to match after-tax contributions into the taxable brokerage account. This concluded that “if a Roth 401(k) has a 0.73% annual benefit, then so does a traditional 401(k) under the same parameters.”
So, there you have it!
The bottom line
You have to decide if it’s worth locking up your funds until you’re 59.5 for roughly 73 basis points. For me, it was not worth it (I was at 700 basis points). I never maxed out my 401k solely due to fees, so essentially I skipped Step 4 on the PEMDAS order of operations for investing and chose to load up my taxable brokerage account.
Contributing to a 401k is not a bad thing. I just want you to take into consideration some data and decide for yourself if you would rather allocate more money to a taxable brokerage account if you plan to retire earlier than 59.5 and if the fees within your 401k are exorbitant.
If you’re someone who has a 401k with high fees, but lack discipline and education when it comes to investing, then I’d actually recommend investing in the 401k provided to you. I’d rather you invest with high fees than not invest at all.
Personally, I’d rather my money be a bit more liquid, and I trust myself to be disciplined to invest in other investment vehicles on a regular basis. So I had a dramatic breakup with my 401k and many hot dates with my taxable brokerage account.
Cheers,
LP
