Last time, we talked about the good news about your 401(k).  So what’s the bad news?

A lot of people I talk to in the financial industry have unpleasant things to say about the 401(k). Some call it the biggest rip-off in history. That may be a little harsh, but few dispute the charge that 401(k)s were set up for the purpose of advancing the cause of mutual funds, which is where most of the money from such programs is invested.

One negative aspect to 401(k)s is hidden fees. Fees associated with 401(k)s should be disclosed transparently on the statements provided to employees, but many times they are not. Many of these fees are referred to in the financial community as “inner fees” or “production fees.” They are sometimes difficult to parse out from the other information that appears on the statement. They sometimes take the form of “management fees,” which is another way of saying sales commissions. These are fees that you pay out of your paycheck, but likely didn’t knowingly agree to.

In most cases, employers contract with a fund manager to come into the workplace and enroll employees into the program. These folks are the ones who should — but often do not — provide full disclosure on these fees and commissions.

Another item on the list of 401(k) drawbacks is possible market loss. When untrained investors see their accounts lose money, they sometimes make investment decisions emotionally. They see the market ebb and flow and watch their money fall and surge with it. To some, this is maddening, especially when they’re in the “red zone” — within 10 years of retirement. They either change their allocations based on fear, or attempt to time the market by moving in and out of mutual funds to their disadvantage.

Roth 401(k)s?

A few companies now are allowing employees to contribute to a Roth 401(k). That provision was approved by congress in 2006. If the company offers this type of plan, employees have the option of amending their plan document to elect Roth-type tax treatment. They can do this for either a portion, or for all of their retirement plan contributions.

In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre-tax dollars are those that do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least five years after the first Roth contribution and the attainment of age 59 1/2, unless an exception applies.

A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example younger workers who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket upon reaching retirement age. Also, higher-income workers who wish to save the maximum amount allowed may favor the Roth 401(k) because it effectively allows greater real contributions, as post-tax dollars are more valuable than pre-tax dollars.

Tax the seed or tax the harvest?

To understand the advantages of a Roth 401(k) over the traditional 401(k), imagine that you are a farmer and it’s planting time. You are standing there with your bag of seed, ready to sow your crop, when along comes Mr. Taxman. He politely takes off his top hat — the red, white and blue one with the stars on it — introduces himself and clears his throat.

“Mr. Farmer,” he says to you. “I’m going to give you a choice. Either you can pay me tax right now on that little bag of seed you have in your hand, and I will consider it a done deal, and I will go away forever and leave you alone, or, you can pay me no tax whatsoever today on the seed, but I will come back every year and tax you on the harvest.”

“Let me get this straight,” you say. “If I pay the taxes on the seed today, I’m done with it forever?”

“That’s right,” says the taxman.

“But you will let me slide on paying the tax on the seed today, if I agree to pay you tax on the harvest forever and ever as long as a crop comes in?”

“That’s right,” says Mr. Taxman. “So, what’s it going to be?”

It’s a no-brainer, isn’t it? You will choose to pay the tax on the seed. Otherwise, each year, when the ears of corn are ripe, Uncle Sam comes by and taxes you on each and every ear of corn you pull off, and repeats the process for years.

It’s that way with Roth 401(k)s. You pay the tax going in, but never pay taxes again on either that money or the amount by which the account grows. So, since Roth 401(k)s are clearly more advantageous to the long-term saver/investor, why aren’t more companies offering Roth 401(k)s to their employees? Good question.

The excuse heard most often is that it would require more administrative help. I tend to doubt that is the real reason. I believe it is a lack of public awareness. Not many employees understand the benefits of such a plan, if they even know that it is available to them at all. Once enough people in the American workplace become aware, however, they will ask about it, and companies will feel the pressure to keep up with the times. After all, the reason why companies provide retirement programs to begin with is to attract loyal, competent employees who will stay with them for decades.

 

Coach Pete and his team offer complimentary retirement strategy sessions to Chapelboro readers.  Contact them at 919-657-4201.