Retirement accounts are largely a scam. They are set up to make you feel richer than you are and create a false sense of security that does not exist. Most of the fund managers within the 401K structure also underperform the market making it an overall bad investment. That said, since many people will be forced to work in a Career or Job for their first 3-5 years of life, lets walk through all of the ways to work the system in your favor.
Where to Put The Money
First Priority Emergency Funds: Lets say you’re starting your career. Instead of maxing out your accounts it makes a lot more sense to save a chunk into an emergency cash fund first. Maybe you’ll hit a recession, maybe you won’t. It just doesn’t make any sense to take that type of risk when you’ve got nothing in the bank to start. We used to think that maxing out the account was the smart move since your tax rate “may go up… That is now a dead idea. Instead, first priority is putting an emergency fund away so if everything goes south you’ll have money in the bank just in case.
Contribute the Match: If your Company has a match, this is where you’ll happily go up to the percentage match. After all, you plan on starting a Business and want to be financially independent before you’re 40 (otherwise we have no idea why you’re reading the blog!). Since you’re all in on being rich young enough to enjoy it, you’ll only put in the match. Typically this is around 3-5% or so. Therefore if you make $100K you’re going to put $4,000 into the retirement account assuming that the match is 4%. This will result in a total contribution level of $8,000. That is factually a 100% return and is worth it. Even if you pay penalties to pull the money out that is still going to be worth more than $4,000 (post tax).
Contribute to Pre-Tax Only: Never pay the taxes on it up front. Unless you are 100% certain you’re going to jump into a new tax bracket within a year (still working a Career for example) then it does not make any sense to pay taxes on it immediately. Put it into a Pre-tax retirement account and get the 100% match. Do not take mainstream advice that taxes will only go up in the future, in fact they may go *down* during this Presidential term. We’re not making a prediction since we’re not really interested in retirement accounts anymore but if it does change, you may want to look at ways to get it out (more on that below).
Summary: You’re going to put away a chunk of emergency funds. Then you’ll only contribute the Company match (we no longer recommend maxing out for our current readership). All of this money will go into *Pre-tax* funds.
Choosing the Right Fund
Mirror the S&P: Make the commitment that you’re not interested in working a dead end job/career for 40 years in the hopes of enjoying life at 60. Again, we don’t think you’re in that group given our readership data. With this in mind the money is only going to go into equities. Since you have a 40 year horizon, there is no reason to own a basket of bonds/treasuries/fixed income if your goal is to create a growth portfolio over a 40 year horizon.
Screen Your Options: There is a huge movement to avoid fees and Personal Capital can do that for you with its fee analyzer tool. We cannot recommend a fund because we do not know where you will be working. Every firm has a different set of funds so you’ll have to do the dirty work (won’t take long) and find every single fund where the goal is to mirror the S&P 500. Since we recommend you eventually venture out on your own, avoid all of the structured products that change your portfolio as you get older. “Set and Forget” into the fund that closely mirrors the S&P 500.
Monitor 1x a Year: Every year, the funds may change. Your Company will send an update or add new retirement related products. Simply check to make sure you’re still in the lowest cost fund that mirrors the S&P 500. After that you’re entirely done with choosing and monitoring your retirement assets. You will not look at the balance. Since you’ll monitor the fund choices 1x a year you can go ahead and make sure you received the Company match and move on (wipe it from your mind).
One Time Events
New Tax Bracket Change: If you are going to switch firms and jump up into a new tax bracket it may be worth it to roll over the entire fund into a Roth IRA. You’ll pay the tax on it but you can then withdraw the entire principal *penalty free* in five years. This is an important point. If you have $30K in a 401K and jump to a new firm that will move you from tax bracket 1 to tax bracket 2 forever… Go ahead and roll this over into a Roth IRA. Paying the tax on it upfront will hurt, but it won’t matter because your tax rate is going to go up anyway. After five years have passed you can now take out the principal in a worst case scenario. For bonus points if you move from a high tax state to a tax free state you can avoid paying state taxes. Just make sure your residency has officially changed and then flip the money over.
Real Estate: If you love the city you live in and would like to purchase a property, you can use $10,000 and avoid paying any penalties on it as well. This is another great reason to get the Company match. Lets say you’re moving from State 1 to State 2 (a place you’d love to live forever), when you move… it may be a good time to buy that first property. To keep it simple, if you had $5,000 and got a $5,000 match, you’re now unlocking ~$6,000-7,000 post taxes despite contributing the equivalent of ~$3,000-3,500 on a post tax basis.
Summary: You’re going to mirror the S&P with the funds offered by your Company. Ideally something that is practically equivalent to an ETF of the S&P 500. After that there are two scenarios where you can unlock more value with 1) roth IRA roll over assuming you are certain your tax bracket will change for the next few years and 2) using $10,000 to fund part of a real estate purchase.
That is our summary of retirement accounts and you’ll never have to search for it again on this website. We used to recommend maxing them out but… that just doesn’t make any sense. All it does is lock up slightly more money for a longer period of time when you should be financially set *well* before you’re anywhere near 60 years old. If you’re financially set, the money sitting in these accounts are essentially meaningless.
Why Retirement Accounts Will Be Meaningless
When you begin making money from your product based Company, you’ll no longer care about your Retirement accounts. This is due to life style changes and the need for cash flow over net worth. Do you really *need* $500,000 in retirement if you’re already financially independent? The answer is no of course. If you’re already making enough passive income to more than cover your cost of living, there is no need for the extra money that will be available at age 60 (or higher if they change the laws).
Psychology of Retirement Accounts: It seems that retirement accounts were set up to make people feel richer than they really are. When calculating net worth it should always be done on a post tax basis. How is $500K in a 401K account equal to $500K in a brokerage account? They are 100% unequal. Even if the retirement account is all post tax money… It still doesn’t work. There is a 10% penalty to be paid so it would be 90% of that value. Either way. The account offers a false sense of security because it seems like you have more money than you do. $500K in a pre-tax account is = to somewhere around $250-300K.
Retirement Accounts Offer No Cash Flow: Since the money can’t be withdrawn without penalties, it certainly does not offer any cash flow. So for 40+ years you’ll see $0 except for the psychology of knowing there is money floating around in a financial system out there… that can be obtained for an outrageous penalty. Without the cash flow it doesn’t help you live your day to day life once you’re financially independent (money is locked up for over 30 years… assuming you’re a millionaire within 10 years).
Forced Check Ups: This is probably the biggest drag. Who is running the retirement account? If you’re in an awful situation where all of the offerings are fund managers charging 1% for something that mirrors the S&P 500, you’re in trouble. You’ll likely underperform the market which is not good. So you’ll be thrilled when you you’re officially done working and take all the retirement accounts over to Vanguard for the lowest fees possible to mirror the S&P.
Why You Won’t Want to Retire
Here is the kicker. Most people (not our readership) long for retirement because they don’t want to do repetitive tasks that make someone else richer. Over and over and over again. Instead you’ll want to strike it out on your own and make money for yourself (only way to get rich is with a business). Once this happens and you begin making money on your own, you’ll have no interest in sitting on the beach all day. You’ll be interested in earning money from your new venture.
Once this becomes exciting or “entertaining” for you, there is no turning back. There is no reason to stop earning money from your venture because you enjoy it. Who would retire from doing something they enjoy?
The question laid out above is very important. Retirement accounts are set up under the *assumption* that you hate working. Therefore, the entire system knows you’re unhappy working. Now… Who would want to be part of that system?