Arguments Against Investing In A 401K

The common 401k plan is universally praised by almost every financial journalist around, including most of the blogosphere (me included). The advantages are touted endlessly: tax deferral on gains, a current tax deduction, the company match, etc. A growing number of bloggers and journalists, however, have been questioning not only the wisdom of relying completely on your 401k for retirement (which I don’t recommend) but on the wisdom of investing in a 401k at all. According to these bloggers, the downsides of investing in a 401k often far outweigh the upside. Here are some common arguments against investing in a 401k.

Arguments Against 401ks

• Tax Rates Will Rise - A tax break today doesn’t seem like such a good deal anymore if you end up having to pay a much higher rate upon withdrawal. With a $10 trillion national debt, continuing budget deficits, and staggeringly large entitlement obligations for Social Security and Medicare, many if not most observers predict the U.S. government will have no choice but to raise taxes significantly in the future. After all, we can only live off borrowed money for so long. If taxes are raised significantly in the future, the scales tip more in favor of paying taxes now rather than later. A Roth IRA would be the most obvious alternative.
• You Owe Income Tax On All Gains – In a 401k, there is no such thing as a capital gain: it is all considered regular income by the IRS and thus taxed at the highest possible rates. For some asset classes that throw off a lot of taxable income such as corporate bonds or REITs, this is fine since relatively little of their long-term return comes from capital gains. For low-cost index funds, growth stock mutual funds, and other low-turnover, equity-based investment strategies, however, this is a significant disadvantage. Since practically all of an index fund’s return comes in the form of long-term capital gains, the value of the tax deferral is minimized: these funds would be very tax-efficient anyway. “But you still start with more money in the beginning because you save on taxes,” you might say. This is true, but that isn’t necessarily enough to overcome the twin disadvantages of high-cost, low-quality investment choices prevalent in most 401k plans. Lazy Man And Money does the math here.
• 401ks Have Expensive, Sub-par Investment Options – On average, I have found this to be true. Sure, some larger companies administer their 401k plans through Vanguard or one of the other top mutual fund companies and offer low-cost, high-quality investment options to their employees but in my experience, this is rare. I have never in my life had a decent 401k plan, in fact. Many contend it’s better to forgo the tax deferral in favor of superior investment options, and this is certainly sometimes the case.

What’s The Alternative?

The three points above are all valid reasons to skip the 401k, depending on your individual circumstances. You should do your own homework to determine if a 401k is right for you. If it’s not, what’s the alternative?

• Pay Down Debt – Paying down all your high-interest debt is an excellent alternative to investing in a 401k.
• Invest In A Roth IRA – If you qualify, a Roth IRA is a great destination for your investment dollars. You can open an account anywhere you like and withdrawals are completely tax-free.
• Invest In A Taxable Account – No tax advantages, but at least you have full control over your investment options and can withdraw your money at any time for any reason
• Real Estate – If you know what you’re doing, an investment in real estate can pay huge dividends even in today’s market.