Common 401(k) Assumptions Debunked: Inflation, Tax Brackets, Company Stock, and Fees
Is my 401(k) the best place for all of my retirement savings?
The short answer: No
There are many different types of 401(k) plans and some are better than others. In general, you hope that your workplace 401(k) plan has low fee mutual funds along with low management expenses. It’s also desirable for your 401(k) to have a point person, or offer access to professional advice for your questions.
If your 401(k) investment choices are filled with high fees, actively managed mutual funds, company stock, or other less desirable choices you need to consider other types of accounts for your retirement dollars. In this case, only invest enough in your employer’s 401(k) plan to receive the company match, and invest the remainder of your retirement savings in a Roth IRA or traditional IRA outside of the company plan.
If I invest the minimum in my 401(k), then I’ll have enough retirement savings
The short answer: Absolutely not
This is absolutely false. What if you’re age 35 and you invest $100 per month for 30 years in your retirement account. Let’s take a conservative approach and assume that the $100 is invested each month in a fixed bond fund with an average rate of return of 3% per year. At age 65, your account will be worth $58,419. You’ll have invested $36,000 over 30 years and that money will not even double during the time it’s invested.
According to the Social Security Administration, “The average monthly Social Security retirement benefit for January, 2016 is $1,341. The amount changes monthly.”
You need to invest enough money and receive high enough returns to give you greater growth than 3% per year. Social Security won’t be enough to fund most people’s retirement, thus you must make up the difference. In general, you’ll need to invest at least 10% to 15% of your income, depending upon your age, in both stock and bond funds in order to have a comfortable retirement. Develop a reasonable asset mix and invest enough per month to fund the difference between your expected Social Security benefits and your financial retirement needs.
I don’t need to worry about adjusting my retirement target for inflation, since it’s been so low
The short answer: Adjusting for inflation is crucial.
Many of the retirement calculations ignore inflation. In fact, since 2008, we’ve only had one year where inflation hit 3%, and that was 5 years ago in 2011. Consider this reality, if you were born in 1988 and were given $10,000 at birth, when factoring in inflation’s impact, it would take $20,129 to purchase today (2016) what the $10,000 bought in 1988. That means, you need to invest your money for retirement so that it will grow and compound more quickly than inflation.
Put another way, with an inflation adjustment, an investment in the S&P 500 stock index in April, 1988 would yield an annualized 4.991% return versus a 7.279% return without considering inflations impact. When calculating your future investment returns, don’t forget to factor in inflation.
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Will my tax bracket be lower when I retire?
The short answer: It’s complicated!
Retirement investing requires making assumptions. When you invest in your 401(k), you are saving on taxes today, with the expectation that when you withdraw your retirement money in the future, you’ll be in a lower tax bracket. Yet, this may not be the case.
Just like we strolled down memory lane in the previous inflation myth section, let’s do the same with taxes.
Notice that marginal tax rates haven’t been as low as they are now, since the 1920’s and 1930’s. During most of the 1900’s the marginal tax rates were much higher than they are at present. This fact raises the question, “Are you certain that you’ll be in a lower tax bracket when you retire?”
You may assume your income will be significantly lower in retirement, yet, remember that at age 70 ½ you’re required to withdraw from all of your retirement accounts except your Roth IRA. This required minimum distribution (RMD) will likely pump up your taxable income. Don’t assume that you’ll be in a rock-bottom tax bracket in retirement. In the future, income tax rates may drift upward and your taxable income may not be as low as you expect. When doing your retirement planning consider that your tax rate may not be lower when you stop working than it is today.
My 401(k) is free and I don’t need to think about fees
The short answer: The myth that 401(k) investing is free is rubbish.
There are a variety of fees you may be assessed when investing in your 401(k). The U.S. Department of Labor encourages consumers to look at fees when investing in their employer’s plan. Following are sample fees you might encounter in your workplace retirement account:
- Plan administration fees: These cover the day-to-day operation of the program.
- Investment fees: Every mutual and exchange traded fund (ETF) charges a fee, generally charged as a percent of assets under management. The lowest fee index funds might charge 0.05% whereas an actively managed mutual fund could charge up to 1.50% or more.
- Sales charges: Some investments come with a special commission fee, charged when the particular investment is bought and/or sold. These fees may be also be called ‘loads’.
- Service fees: These charges might be a flat monthly amount or a specific expense for participating in special plan features.
>Related article: Average 401(k) Fees
It’s best to buy as much company stock as possible at a discount
The short answer: Be careful!
Many employers offer employees the opportunity to buy company stock at a discount. Don’t assume that this is a “can’t miss” opportunity. Regardless of how fabulous your company is, consider the importance of keeping your retirement monies diversified. Imagine if your company hits a rough patch and the company stock value tanks. Then, for added injury, you’re laid off.
This is a major problem with over-investing in company stock. With the average 401(k) plan participant holding more than 7% of her investment portfolio in company stock, according to the Investment Company Institute, you may be accidentally setting your portfolio up for future losses.
Diversification is the bedrock of successful investment management. The benefit of maintaining a diversified investment portfolio is that when one stock, fund, or asset class tanks, you’ll have others that counteract the drop and increase in value. If you have too much invested in your company stock, even bought at a discount, you’re opening up your financial future for the possibility of excess volatility and loss.
Although the 401(k) is a wonderful type of account with many financial benefits, it isn’t perfect. Be aware of 401(k) myths in order to shield your future self from unpleasant financial surprises.
For more helpful, actionable 401(k) advice, check out 6 Important 401(k) Mistakes to Avoid and Your 401(k) is Underperforming the Market: What Should You Do?
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