"The 401(k) will turn out to be the greatest systemic financial hoax ever perpetrated on an unsuspecting public."
- William Wollman, The Great 401(k) Hoax
Like most people I was told to plow as much money into my 401k pension plan as possible. So like millions of other workers out there, I did as I was told. By 2003 I had accumulated a nice little nest egg...that I couldn't touch. Then one day I was in a bookstore and I happened across a book called The Coming Generational Storm. What I read about 401k's that day made me immediately stop all contributions.
Since then I came to realize that the 401k model is hopelessly flawed and will lead an entire generation to despair. Author Laurence J. Kotlikoff made two points that were simply too logical for me to ignore:
1) 401k money is tax-deferred, not tax-free. Therefore, by putting money into a 401k and getting the tax break now, you are making a bet that taxes will not be significantly higher a couple decades from now when you retire.
Will taxes be significantly higher when you retire? Unless the federal government simply defaults on its Social Security and Medicare promises then taxes will have to be raised significantly. Even if they aren't, 401k's are a very questionable investment for the lower and middle class.
The lifetime tax increase and spending reduction experienced by low and moderate income
households from participating fully in 401(k) and similar tax-deferred vehicles arises for three main reasons. First, withdrawals of tax-deferred balances push households into higher tax brackets in old age. Second, contributions to tax-deferred retirement accounts lowers one's tax brackets when young and, consequently, the size of the tax break from itemizing mortgage interest and other deductions. Third, and most importantly, withdrawals of tax-deferred balances when old can trigger much higher levels of Social Security benefit taxation under the federal income tax.
As can be verified in Table 12, for a young couple with $50,000 in initial annual earnings that earns a 6 percent real return, partaking fully in the typical 401(k) plan raises lifetime tax payments by 1.1 percent and lowers lifetime expenditures by 0.4 percent. The lifetime tax hike is 6.4 percent and the lifetime spending reduction is 1.7 percent for such households if they receive an 8 percent real rate of return. These figures rise to 7.3 percent and 2.3 percent, respectively, if taxes are increased by 20 percent when the couple retires.
Kotlikoff then goes on to elaborate that couples making $300K a year get a larger tax break (as opposed to middle-income earners) from participating in a 401k. This disparity is a legacy from the Reagan's Administration, where they cut progressive income taxes, while raising regressive payroll taxes.
2) All of those Baby-Boomers are expecting to use those stocks and bonds to fund their retirement. To put it another way, starting next year and increasing every year after that for more than a decade, the number of people who were buying stocks and bonds are increasingly going to be selling those stocks and bonds (the WSJ estimate $300 Billion a year, every year).
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