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The Problem With 401(k)s–and What to Do About It


“It is well enough that people of the nation do not understand our banking and monetary system. For if they did, I believe there would be a revolution before tomorrow morning.”

—Henry Ford

The following is an edited excerpt from the new book, Heads I Win, Tails You Lose by Patrick Donohoe.

Believe it or not, 401(k)s were never created to be retirement plans. And yet they remain the primary financial vehicle through which most Americans save for retirement.

How did this happen?

Let’s start by considering the motivations of the people who created 401(k)s: Wall Street bankers.

Simply put, these institutions have four rules:

  1. Get money.
  2. Get money as often as possible.
  3. Keep the money for as long as possible.
  4. Give as little of the money back as possible.

As pensions became too much of a burden for companies, the 401(k) was the ideal alternative. It aligned with every motivation above.

The advent of the 401(k) as the primary retirement savings vehicle today was an unintended consequence, primarily stemming from the ideas of a financial advisor named Ted Benna.

Benna developed the 401(k) as a way to help executives defer end-of-year bonuses–he never intended it to become what it is today.

However, because it aligns perfectly with the four rules of financial institutions, it remains, despite its challenges, the go-to vehicle for Americans to secure their financial future. Despite its ubiquity, the 401(k) is not your best option for retirement investing.

In this article, I’m going to break down exactly how a 401(k) fits the needs of Wall Street and employers, why those needs aren’t the same as your own, and what to do about it.

1. Get Money

A successful financial exchange between any two parties requires a mutually agreed upon outcome where both parties get what they want. Upon its inception, the 401(k) fit this role: the participants and the bankers both got what they wanted.

In general, the participants in a 401(k) want financial benefits such as earnings, tax benefits, and the confidence that their money will grow sufficiently to cover their expenses when they stop working.

Before the development of the 401(k), a pension used to fit this need for working Americans, guaranteeing them income for as long as they lived after retirement.

However, when the 401(k) arrived on the scene, it was became the superior choice for employers.

Rather than promising their employees a fixed income after retirement, they created an investment vehicle that had less liability and less hassle, while still offering employees the same promise of retirement to the employee.

The 401(k) has been a win-lose compromise (against your needs) since its creation.

Wall Street has done a phenomenal job of convincing the American public of a different narrative: the 401(k) is a superior investment vehicle, and nobody should expect a pension.

By accepting this narrative, you shift the burden of retirement from the shoulders of Wall Street directly onto yourself.

2. Get Money as Often as Possible

In 1981, adjustments to the 401(k) section of the tax code allowed employees to make contributions through a payroll deduction.

In 2006, through the Pension Protection Act legislation, employees were automatically signed up for the plan unless they manually opted out. Automatic contributions and enrollment greatly increased the amount of money Americans put into their 401(k)s.

By charging fees to run your account, investment bankers are getting more and more money from people every payday.

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3. Keep the Money for as Long as Possible

Your money is untouchable in your 401(k); you can’t touch it without paying significant penalties until you retire or reach age 59½.

If you’re currently employed, regardless of your age, you can’t withdraw at all. If you change employers, you can roll it over, but you still can’t use that money until you meet the employment or age requirements.

In other words, even if you have a big pot of money in your 401(k), the only way to get to it involves paying penalties. These plans have a serious drawback of lacking liquidity.

The supposed incentive to you is that you don’t have to pay any taxes at efile time on your contributions or gains up to a determined limit.

However, you will still have to pay taxes on that money when you withdraw it in the future.

From a tax perspective, this may make sense for you. If your tax rate now is more than your tax rate when you want to withdraw the money, deferring your income may save you some money. That ideal scenario isn’t guaranteed.

Your 401(k) is regulated by the tax code, which can (and does) change when new laws are enacted. If Congress decides the country needs more money, the tax code can change.

The vast pool of 401(k) money makes a tempting tax target.

4. Give as Little of the Money Back as Possible

One of the main incentives to contribute to a 401(k)—to defer income taxes—becomes, oddly enough, the primary disincentive to withdraw from it: having to pay income taxes!

Additionally, income tax rates may be higher in the future than they were when you contributed. Here’s why that is likely to happen.

Fiscally, the United States has seen better days. With the looming budget deficit sitting at tens of trillions of dollars and Social Security and Medicare obligations at more than double that each, the most likely means of meeting these obligations is increased taxation.

David M. Walker, who served as Comptroller General of the United States from 1998 to 2008, has stated on many occasions the dire condition of these future obligations, mainly the deficit and healthcare expenses. He predicts taxes will rise 200 percent from their levels today.

Although it is not certain, an increase in future taxes is a good bet.

How to Break Away from Wall Street

Wall Street isn’t what it used to be. The vast inflow of 401(k) money since the 1980s has made mutual funds very popular and has incentivized fund managers to make money off fees and commissions. Those costs get passed down to you.

The risk isn’t worth the return. The money you put into your 401(k) is subject to market volatility, inflation, taxes, and fees, while returns on the investment are low.

Breaking away from the Wall Street mindset isn’t easy. You must go against what everyone else is telling you to do and think for yourself. In order to make the most of your retirement money, you have to do what’s best for you, not what earns the most fees for Wall Street.

For more information on unique financial strategies to better plan for your retirement, pick up a copy of the new book, Heads I Win, Tails You Lose by Patrick Donohoe.

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Patrick’s bio:
Patrick Donohoe is the president and CEO of Paradigm Life and PL Wealth Advisors, companies he founded to teach clients how to build wealth, create income for life, and leave a meaningful legacy to those who will inherit their assets. Patrick is a popular speaker at wealth management and investment seminars and hosts The Wealth Standard podcast, a popular financial podcast. Patrick grew up in West Hartford, Connecticut, and attended the University of Utah, where he received his bachelor’s degree in economics. He lives in Salt Lake City with his wife and three children.

Sean Jacobson

I'm Sean, a former HR and business consultant providing you insights into the business world for Leader to Leader.

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