Make no mistake: Borrowing from your 401(k) is rarely a good idea when it comes to financing your business. Still, it can be and has been done.
First, the pros: the possibility that 401(k)s actually aren’t all they’re cracked up to be in the first place. The 401(k) is often considered the gold standard of retirement plans. But far from being a sure thing, the 401(k) started as an experiment in 1981 and still has to prove itself.
Those workers who decided to be 401(k) lab rats in the first test group are just starting to get back their results. After 30-plus years of faithfully funding their retirement plans, it’s time to retire and the past 15 years haven’t been kind to them. It turns out that the supposedly dependable 401(k) isn’t your best choice for retirement -- not by a long shot.
Garrett Gunderson, founder and chief wealth architect of Wealth Factory, which offers personal financial education for entrepreneurs, has worked with hundreds of professionals. Most of them diligently saved in a 401(k), but once he explains the risks, they’re eager for alternatives. According to Gunderson, here are seven dangers of a 401(k) for you to consider:
1. You can be wiped out overnight
A 2009 report that appeared on the long-running CBS TV newsmagazine 60 Minutes asked of 401(k)s, “What kind of retirement plan allows millions of people to lose 30 to 50 percent of their life savings just as they near retirement?”
Unlike other investments that are protected from losses, your 401(k) rises and falls with the stock market, where you have absolutely no control. Retirement planners will tell you the market averages 8 to 11 percent returns per year. That may have been true in the 20th century, but this century has seen that turned into a fiction. From 2000 to 2015, the market was up just 8.4 percent total when adjusted for inflation, or 0.56 percent per year, and that was after a substantial market rally. Do you want to live your ideal life only if the market cooperates?
2. Administrative fees and the tyranny of compounding costs
The toll taken by 401(k) and associated mutual fund fees is staggering, and it can eat up more than half your gains. With 401(k)s, there are usually more than a dozen undisclosed fees, including legal fees, trustee fees, transaction fees, stewardship fees, bookkeeping fees, finder fees and more.
But that’s just the beginning. The mutual funds inside 401(k)s often take a 2 percent fee off the top. If a fund is up 7 percent for the year, they take 2 percent and you get 5 percent. It sounds like you’re getting more, right? At first, yes, but in the end, the mutual fund wins.
If you contribute $5,000 per year from the time you’re 25 until you’re 65, and the fund goes up 7 percent every year, your money would turn into about $1,143,000. But you’d only get to keep $669,400, or less than 60 percent of that total. That’s because a 7 percent compounding return adds up to hundreds of thousands more than a 5 percent compounding return, and none of it goes to you. The mutual fund’s 2 percent fee cuts the return exponentially. In the example above, by the time you turn 75, the mutual fund may have taken two-thirds of your gains.
Bogle puts it like this: “Do you really want to invest in a system where you put up 100 percent of the capital, you take 100 percent of the risk and you get 30 percent of the return?”
The theory behind 401(k)s is you keep putting money away where you can’t easily touch it without penalty for 30 years, and it will compound into enough to retire on. But money left to compound unpredictably for 30 years is stagnant money. There’s no cash flow ready to direct to today’s best uses. Instead, it’s sitting still inside one 30-year bet, while newer, better opportunities may be passing you by.
3. Lack of liquidity when you need it most
Money in a 401(k) is tied up with penalties for early withdrawal unless you know how to safely navigate obscure IRS codes. This means you can’t spend or invest your money to enrich your life by using it to start a business without great difficulty and/or a big financial hit. The only exception allows you to borrow a limited amount of money from your 401(k) if you promise to pay it back.
This automatically leads to double taxation and a slew of other negative consequences, the worst being that if you lose your job or your income dries up, the deal changes and you must repay the loan within 60 days. Not even loan sharks are that cruel.
4. Fear of taxes leads to underutilization
All 401(k)s are tax-deferred, meaning you avoid paying taxes today by committing to paying them later. But taxes are historically low compared to the 50, 60 or even 90 percent marginal rates of the past, and chances are, with record national debt, that taxes are going up. If you don’t like paying taxes today, why would you want to pay more taxes in the future?
5. Higher tax brackets upon withdrawal
It’s ironic that people anticipate they’ll have healthy returns on their qualified plan while at the same time figuring they’ll be in a lower tax bracket at retirement. If you’ve achieved any measure of success, you should actually be in a higher tax bracket at retirement. Most advisors, however, assume the opposite. Even worse, those higher tax brackets are likely to be even higher and more daunting in the future.
6. The government owns your 401(k) and can change the rules at will
You may be surprised to learn this, but your 401(k) doesn’t even technically belong to you. Read the fine print, and you’ll find the term “FBO” (For Benefit Of). The tax code makes it technically owned by the government but provided for your benefit.
Judging from world history, 401(k)s could be in great jeopardy. Other countries have raided private retirement plans to fund the government. Argentina did it in 2008, Hungary did it in 2010, and Ireland in 2011. Similar pension raids occurred in Poland and France.
Could it happen in America? Well, during the last recession, Congress invited an expert to give testimony on confiscating 401(k)s and turning them into a public retirement plan like Social Security. It only takes one economic crisis before you retire for possible rule changes or confiscation of your 401(k).
7. Turmoil in retirement
When it comes time to withdraw money in retirement, maybe you can stomach the taxes, but can you stomach the market swings? Suppose you’ve projected to withdraw 6 percent a year, based on an average annual return of 8 percent. What will you do when the market is volatile?
If your fund is down 10 percent one year, any withdrawal is tapping into your principal. At that point, your only choices are to start withdrawing principal or leave the money alone until your account is up again. Try sleeping at night when your income is at the complete mercy of the markets.
In short, saving for retirement is wise and prudent. But other investment philosophies, products and strategies can meet your financial objectives much more quickly and safely than a 401(k). Investing for cash flow, investing directly in a business or “cash flow banking,” where you become your own “bank,” could be smarter moves. Even paying off a high-interest-rate loan can be a better bet than contributing to your 401(k) if you plan to use the money to start a business.