The Good and Bad of 401ks

 
401kHighwayI believe blanket statements are too simplistic and that’s why I flipped out on James Altucher for saying that people in their 20s should not invest in 401k plans. That’s dumb advice, so here’s my reasoning why 401k plans are a good investment, but not the best, and why they should be part of your investing life but not the only part. If you’re a numbers geek then you’ll love this post.

One of the completely idiotic statements James made was that you’ll only get a 1/2 percent return on a 401k so let’s take a look at my experience. A few things: I’m a consistent investor who believes in buy and hold and favors index funds over actively managed funds. Obviously I’m not going to use my actual account balances so instead I’ll use a hypothetical based on about $1,000 invested over 18 or so years which is how long I’ve been in the 401ks I’m using for this example.

Let’s say my current 401k account balance is $4,180. There are four parts that make up this balance:

1. How much I invested over the years

2. My company matching funds – free money

3. Dividends that are reinvested

4. Growth – what James Altucher said would be about 1/2 a percent (I’m shaking my head writing that)

My investments, the money that came out of my paycheck, accounts for 23.4% of that total or $978.12.

The company match, the free money James didn’t even mention, accounts for 5.1% or $213.18.

The dividends were a big part of this and is the reason I have mutual funds that pay higher dividends in my tax deferred retirement accounts, another item James was not impressed with but can be very important. You don’t pay taxes on dividends in a tax deferred account! So the dividends were 18.6% or $777.48.

Add all that up and you only get $1,968.78 far below my balance of $4,180 so where is the rest? The rest is growth over 18 years and accounts for 52.9% of the value of my 401k balance. That’s a lot more than the 1/2 a percent James mentioned is his video. Also of note is that this includes the huge losses in 2008, losses that were quickly recovered because I didn’t panic and stuck with my plan.

But in some small way I do agree with James that 401k plans are not always the best option. I have reduced the amount I’m investing in my 401k plan for a couple of reasons. First because the money is locked up until I’m 59 and a half (not 65 as James said in his video). I want to retire early and need money available before I’m 59.5 so I’ve been investing more in my taxable accounts.

Another reason I’ve reduced my 401k investments is so that I have funds available for other investment options like a business I opened a couple of years ago. If all my money was tied up in retirement accounts I’d be investment rich but cash poor like so many people are house rich and cash poor.

One size does not fit all and blanket statements are useless. The power of compounding, as evidenced here, is incredible! So please do invest in a 401k plan as early as possible and put enough money to at least get the full match your company offers (if they offer a match). After that make decisions that work for your situation.


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Doing Tax Day Wrong

 
April 15 is here and you’re either getting a refund or sending a check to the government but either way you’re doing it wrong. 

tax_april_15I’m not saying that you can work things perfectly during the year and owe zero on April 15 but I will say that if you are getting more than a few hundred dollars back or sending more than that to Uncle Sam, you’re doing it wrong.

Making a Payment

Let’s start with why making a payment is a bad idea. Beside the obvious, that no one wants to be surprised with a big tax bill, there are other reasons. First, you’re not being aware of your money. You’re not planning well and that lack of planning is costing you now. The other thing is that Uncle Sam doesn’t like it either – he wants his money on time and will hit you with estimated payments in 2015 to make up for your shortfall.

Refund

This one is a little harder because who would complain about getting a nice fat check in April? Nobody! But it’s still poor planning. You just gave the government an interest free loan. They had your money and now they’re just giving it back. Taxes are not a savings account – or they’re a really bad one. It would be much better off to have the IRS deduct less money from your check so you could invest it – not spend it. Contribute more to your 401k, Roth IRA, or invest in index funds in a taxable account.

Balance

The important thing when playing the tax game is to achieve balance. If you are getting a big refund or owe a lot then make adjustments now to your withholding so that you can be in balance.


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Opportunity and Action

 
Success is not easy, it takes work. Success comes at the intersection of opportunity and action. Opportunity and ActionThere are a lot of people who were at the right place at the right time but didn’t take action, they let the opportunity slip through their fingers. The sad part is that many people may not even realize it.

The first step to success is recognizing potential.

When I was planning to make the transition into financial planning as a career I volunteered to speak and answer questions at informational sessions for National Guard troops and their families that were being deployed overseas. While these men and women, both the soldiers and their families, were sacrificing for their country, they were also being offered unique benefits. (Not that they were enough compensation but at least it was something).

Soldier in DesertOne benefit was that the soldier’s income while overseas was tax free. Even better than that is the fact that they could also contribute to a Roth IRA – that was huge. Why? Because normally Roth IRA contributions are after tax, meaning you pay tax before contributing. When you withdraw the money in retirement it is not taxed so you get the benefit of tax free growth. What these soldiers were being offered was an opportunity to invest money and have it grow without ever, let me repeat, ever, paying taxes.

I was standing at the back of the room when my colleague was making this presentation. A soldier and his wife were standing next to me and the wife pointed out this unusual and generous benefit. “I don’t care about that,” the soldier said. He was in the right place at the right time but unless he acted on that information, the opportunity would be lost. I wonder how many of the people we owe so much took advantage of that benefit.

Taking action is the second component of success.

The other aspect of success is that once you recognize an opportunity, you have to be willing to sacrifice to get the benefit. The soldiers aren’t paid well for their service and diverting $4,000 (the maximum at the time) into a Roth IRA could be a hardship. If they looked far enough into the future, however, they would have seen the benefit of this action but I suspect that many did not.

Are you open to opportunities? Are you constantly on the lookout? Would you be willing to sacrifice, now, for a benefit that is years in the future? Then why aren’t you?

 


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Random Thoughts – Taxes

 
IRSOk maybe I need to get out more on the weekends but it’s cold outside and my wife and I have been painting for several weekends now so I’m stuck inside. On the rare and brief moments I get to check email and other computer related stuff what have I been reading? One item that caught my eye was a headline that said “No, Entrepreneurs Like Steve Jobs Do Not ‘Create Jobs’ By Inventing Products Like The iPhone.” I clicked and it was a well reasoned look at why raising taxes on the super-wealthy (or even just the mere wealthy) won’t “kill” jobs as many politicians say. The article makes a strong case that raising taxes on the wealthy will create more jobs. Oh and it’s not exactly on a liberal website, it was on Business Insider.

Reading the article referenced above I was reminded of Henry Ford who once encouraged other manufacturers to hire workers that previously had been laid off. If they didn’t, Ford wondered “Who would buy my cars?” The idea is that if workers are paid a decent wage and can afford to buy goods, the economy will do well. A strong middle class is needed for consumption to fuel the economy. If, on the other hand, as we’re seeing today, there is a wide gap between rich and poor with a shrinking middle class, the economy will suffer.

The article was based on an editorial for Bloomberg by Nick Hanauer, a billionaire. Mr. Hanauer is very clear that he is not a job creator, nor are any rich people. Then who is? The consumer. Mr. Hanauer writes:

I’ve never been a “job creator.” I can start a business based on a great idea, and initially hire dozens or hundreds of people. But if no one can afford to buy what I have to sell, my business will soon fail and all those jobs will evaporate.

That’s why I can say with confidence that rich people don’t create jobs, nor do businesses, large or small. What does lead to more employment is the feedback loop between customers and businesses. 

Another problem with this taxes-will-cause-people-not-to-start-businesses line of reasoning is that it doesn’t matter how much I pay in taxes if I earn more than I had before. Imagine there was a flat tax of 30 per cent and I wanted to start a business. If I make $100,000 then I keep $70,000. I’m better off. Now imagine that taxes are raised to a flat 40 per cent. If I start a business and make $100,000 I keep $60,000. I’m still better off. Not as much but still better. It reminds me of the people I’ve worked with who would complain about how much they paid in taxes on their overtime pay. Who cares how much taxes you paid, you have more money in your pocket and that was the purpose of the overtime.

I may not be a billionaire but I’m not complaining if my taxes rise a bit from the historically low rates of today.


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