There was a time in the not-so-distant past when the “theory of decreasing responsibility” was a viable way of determining how to plan one’s retirement.
This theory, which formed the nucleus of retirement planning for decades, held that as people get older, their financial responsibilities will decrease. For example, the mortgage will typically be paid off, and they’ll find themselves with a lighter tax burden and fewer debts.
The theory of decreasing responsibility was behind the idea that you should “buy term and invest the difference.” People were encouraged to avoid products like annuities and life insurance. Instead, they were told to put their investment dollars into mutual funds, bonds, stocks, and qualified plans such as 401k’s.
Unfortunately, that conventional strategy has not worked very well for some retirees; especially those for whom a 401(k) may not be the ideal choice. It seems unlikely to me that taxes in the United States will go down, so the purported tax savings used to lure people into qualified plans may never pan out.
401(k) plans, while they do offer some advantages, have drawbacks as well. Many of these pitfalls are not explained very well to employees considering maxing out their work plans and making 401(k)’s the cornerstone of their retirement plans.
Be aware of these three potential pitfalls when considering a 401(k)
1. Tax savings likely won’t be as dramatic as you’d like. In an age when the state, local, and national governments of the world are staggering under the weight of “unfunded liabilities” and other debt, it seems impossible for taxes to go anywhere but up. If your primary reason for maxing out your 401(k) revolves around tax savings, you might want to become a little more cynical.
2. It’s hard to get the money out. There is a lot said about putting money into a 401k, but very little said about getting it out if the need arises. Due to a myriad of rules, regulations, and stiff penalties, a 401(k) should be considered an illiquid asset. You will incur punishments in the form of penalties should you decide to take 401(k) money out before retirement.
3. Lack of depth in asset class choices For several reasons, the 401(k) industry has agreed that the average worker should have limited options when it comes to asset classes. Typically, plans chosen by employers are limited to five main asset classes that go from “less risk” to “more risk,” Money markets, bond funds, large-cap funds, small-caps, and international funds are generally the only asset classes available to 401(k) participants. While it’s possible to achieve a diversified portfolio within these five asset classes, many people would benefit from having access to mid-cap funds, REITS, high-yield funds, and other funds in addition to those offered.
These are only three of the reasons I think it makes sense to look at alternative retirement planning strategies in addition to, or in place of, 401(k) plans. Depending on your unique situation, you may be able to take advantage of these vehicles to make your retirement dollars work harder.
In future articles, I will examine more of the pitfalls and offer alternatives that could help make your retirement more satisfying, less stressful, and more profitable. In the meantime, take a couple of minutes to hear some of my thoughts about 401 (k)’s.