I remember sitting in a classroom about 17 years and the instructor passed around a Magazine for us to look at. On the cover was a person by the name of Ted Benna, and if you research or look him up you will see that he is called “The God Father of the 401k” or something of that nature. I wanted to add some context to the readers who are yet to listen to Part I of the Reason Why I Hate Your 401K, which is available as a podcast here and I recommend as an introduction to this Part II blog. In celebration of our 10th podcast for “The Retirement Exit”, I decided that this subject was too complex to only share on my podcast so this blog is Part II. Part I (podcast) will share two other important reasons, but Part II (blog) is the biggest reason why I hate your 401k.
I share in that podcast why I hate your 401k, and why I no longer hate my retirement plan. This blog will take into account that my listeners have heard the podcast and pulled up the link to this blog to learn the biggest reason why I hate their 401k. If you are landing here for Part II and have not listened to Part I then it would be in your best interest to listen to the 20-minute podcast first.
I will start this blog where I started the podcast, back in 1978. We all know by now that the president was Jimmy Carter and “Halloween” was one of the hottest movies during that time. I think it is ironic that my journey to get people to retirement has been somewhat of a “Trick or Treat” and this blog/podcast is released in October. I say that because nearly every investment firm I had been a Part of until I launched my own firm was gather assets (retirement funds) by any means necessary. They never focused on educating the client or potential client. I would always be the one in the workshops to ask the question why and everyone would just look at me with that look. That look of “We are in the business of pushing stocks, bonds, and mutual funds, you do not have time to educate the client.” So in order to feed my family, I had to collect the check and move on to the next prospect. If I had time during a visit, I would try to explain or educate the clients, but that was rare. I started teaching classes on the weekend at the community colleges, because I felt people should know and understand the vehicles they were getting into.
As I mentioned earlier, it was about 17 years ago that an instructor passed out a magazine published by “Money.” I think the title was “Why you should dump your 401k” or something like that. I went out and bought a copy of the magazine and I read it front to back. I went into my General Managers office the next day and said, I think people should know this. He said “Jenny we don’t have time to share this kind of information with people.” In so many words, he was saying if you take that time out to explain or educate people you will not meet your sales quota and you will be on the street looking for a job. Nevertheless, he appreciated my willingness to share, but get back on the phones was his final words to me. I have a podcast that I shared called “The Confessions of a Financial Advisor” where I think I shed more light on situations like that.
Fast forward 18 years and I am on record to agree with the sentiment about 401ks, which Mr. Benna shared in that magazine nearly 2 decades ago. Before I reveal the “Number 1 Reason Why I Hate Your 401k”, I think it would be beneficial to share facts first, because the statement is one where not many financial advisors are willing to go on record. I will start with the year and the time in which the 401k was legally created, 1978. At that time we had 25 tax brackets, yes you heard me right 25 tax brackets, and the highest marginal bracket was 70%. (Example A) Now let us take a closer look at the tax brackets and some other things that make my case even stronger. The first observation you notice is there are 25 tax brackets, but if you look at them, pay very close attention to how a person can move between tax brackets very easily. Looking at a single person making (Example A) $52,199 a year, which would put them in a tax bracket of 60%, but what if they wanted to be in a lower tax bracket that year and “keep more back from uncle Sam”. They could essentially just put $ 500 a month or $6,000 a year into their 401k. That retirement contribution would help them move down from 60% to the 55% tax rate/bracket, so on paper they saved 5% in ordinary income taxes that year. We could do the same for other tax brackets and for demonstration purposes move in between tax brackets with putting as little as $500 a month into a 401k plan. This was one of the biggest selling points of the 401k at the time.
Source www.tax-brackets.org (Example A)
Let us look at the following year and see what happens. Before we get there let us stop and see what law passed in November of 1978 on our way to that following year. It was the “Revenue Act of 1978”. Key take away in that act was an amendment to the Tax Code, by reducing individual income taxes, widening the tax brackets, and most importantly reducing the number of tax rates. This Act also added section 401 paragraph (K) and better known as the “401k” to the Internal Revenue Code.
Let us take a look at what happens the following year of 1979 after the Act of 1978. First thing to get out of the way is that there are now 16 tax brackets instead of 25 as indicated the previous year or before the Act. The highest marginal tax rate that year was still 70%, but in order to move down to the next tax bracket we had to do some things differently. Take the same person making $52,200 a year as in the previous year. They would now be taxed at a 55% marginal tax rate, so like the Act announced they would be in a lower tax bracket. Here is the kicker, to move down one tax bracket lower, or in this case, down to 49%, they would have to put $10,700 a year away in their 401k just to move down. (Example B) That essentially means a person would now have to put $891 a month away just to get the same tax movement as the previous year. The previous year was $ 500 a month or $6000 a year.
Source www.tax-brackets.org (Example B)
Before I go any further, let me share something with you. The 401k inventor or the person who actually read the 1978 Act in it’s entirety really did not take full advantage of the Act until 2 years later in 1980. So why share tax rates and brackets with you in 1977 and 1978 you may be asking? I wanted you to see how your “retirement world” can be turned upside down in one year. You can be going along on your way to retirement and you wake up the next day and there is a policy change that totally takes you off course. If the premise of working in a higher tax bracket now or presently, then retiring in a lower tax bracket later on is the case of why I should love your 401k, then wait until you see what happens next.
Let’s add more context and support to the Number 1 Reason Why I Hate Your 401k. Right after the new code took off in 1980 and people starting putting more money into this new type of retirement plan, then 1981 happened.
In 1981 guess what happened, you guessed it another Act. This one we will call “The Economic Recovery Tax Act”. It was massive, it slashed estate taxes, it cut the maximum tax rate down from 70% to 50%, it trimmed business taxes over a 5 year period by $150 billion dollars, it even cut marginal tax rates across the board by 25%. It also did some economic damage as well, and drove interest rates from 12% to 20%, which in turn drove the economy into a double-dip recession. The damage was so bad that not less than a year later in 1982 another Act was introduced. This time it was the Tax Equity and Fiscal Responsibility Act, which repealed most of the Act of the previous year.
Source- Wallstreet Journal
Let us take a look at our 401k saver during this snap shot in time. The same person earning $52,200 in 1983, ( I could give him/her an inflation adjustment of 3%, but I want to keep using the same numbers to show context) would now be in a tax bracket of 45% and would need to put away 10,800 a year or $900 a month to move down to the 40% tax bracket.
Source www.tax-brackets.org (Example C)
Jenny what’s with the history lesson? Why are you taking us on this journey? I gave you my other two reasons in my podcast, but I wanted to write this blog to support the one major reason Why I Hate Your 401k. You should know by now what that number 1 reason is. It is taxes! I get the fact that you owe Uncle Sam, I get that much, but owing him from inside a traditional 401k today sitting here 2018 is just a bad strategy. I say that because I wanted to lay out some facts first, and see if you could draw your own conclusions. You are taxed according to the IRS 401k code or in this case 401k plan. The mere name of the retirement plan is a tax code, for crying out loud! You never really have any say so on what your taxes will ever be or when it will be okay to start drawing from your 401k plan. That is why I hate it in it’s current form.
My closing argument is this, since they introduced the IRS tax code of 401 paragraph (k) (401k) in 1978 there has been about nine major changes to the tax brackets and law. Let me give you a quick grid of the changes here.
If that same person making $52,200 wanted to take advantage of reducing their tax liability today by putting money into their 401k, the numbers work out significantly different. That person would be in a marginal tax bracket of 25% and to move down to a lower tax bracket that person would need to put $13,600 into their 401k plan to reduce their tax liability down to 15%. (Example D) Sure, that is possible, but that would mean you would be living off $38,600 a year. There you have it, the number 1 reason why I hate your 401k. You have no flexibility and you are joined at the hip with the government because you owe them. Sure, you know what the tax rate was when you put the money in the 401k, but your guess is as good as mines, when it comes to what the rate would be later when you get ready to retire.
Source www.tax-brackets.org (Example D)
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