401K Might Not be the Best Way

401K - an expensive way to retire

Nearly everyone is familiar with the term 401K and when asked what it is, most think it is a retirement plan for regular folks.  The plan originates from the IRS tax code section 401(k) the 401K was introduced in 1978 by congress with the passage of the Revenue Act of 1978.  the purpose of the 401K addition to the IRS Code was to limit executives from having too much access to the perks of cash-deferred plans .  It was never meant to be a retirement plan for the regular guy.  The deferment of taxable earnings into the future is only valuable under 2 conditions. (1), you think income taxes will be lower in the future which is highly unlikely,  or (2) you are planning on your future or retirement income being less than it is today, (hint, this is a terrible plan for your future)

401(k) plans require administration, which layer on several fees. These fees themselves are not excessive when compared against the returns; however that is not how the fees are calculated.  The fees typically come from 3 areas Administration, Management and Marketing, these fees are totaled and expressed as a number called and expense ratio.  The expense ratio is calculated on the total balance of the portfolio, not simply subtracted from the rate of return.  Most investors in 401K plans clearly see the expense ratio in the offering documents, but do not calculate them correctly.  For example, in a 401(k) plan with a $100,000 portfolio of mutual funds having an annual gross return of 8% exclusive of fees ($8000) and having an expense ratio is 1.75% most people calculate the cost of the expense ratio as follows; 8% return ($8,000) minus an expense ratio of 1.75% on the gain or $140.00 ($8,000 X 1.75% =  $140) .  That is not how the mutual funds calculate the expense; it is calculated from the entire portfolio balance so the real expense is $1,750 (100,000 X 1.75%).  Your gross annual return of $8,000 minus the fees of $1750 leave you with $6250. If this was not bad enough, there is still one more fee to be paid, the trading fee, for some funds, this can effectively double the expense ratio.  Over time, the fees in a plan like this can amount to as much as 60% of your earnings.  Over time, these fees may far surpass the cost of current taxes saved making this plan more expensive than just paying the tax at the time of earning.

 

The link below is a good resource to understand this topic in more detail

http://www.pbs.org/wgbh/pages/frontline/business-economy-financial-crisis/retirement-gamble/the-retirement-gamble-facing-us-all/

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