Originally published September 17 2008
What Your Employer May Not Tell You About Retirement Accounts
by Barbara L. Minton
(NaturalNews) The number of investors who are hitting up their Retirement Accounts is on the rise. According to the Transamerica Center for Retirement Studies, the number of employees with loans outstanding in Retirement Accounts such as 401(k) and 403(b) rose to 18 percent from last year's level of 11 percent. The anxiety produced by rising gas, food and energy prices is spurring the desire to tap into retirement savings to ease current financial troubles, but many who are making the decision to borrow are not aware of the consequences. In fact, Americans as a whole are sadly lacking in knowledge about the implications of putting their money into Retirement Accounts.
Retirement Accounts are recent phenomena, coming into existence in the early 1980's. Spawned by the desire of employers to shed their obligation for employee's retirement, these accounts are sponsored by employers and sold to employees as panaceas for funding glorious retirements. Employees were often left in the dark as to the downside of this type of savings vehicle, and just who it is that really benefits from Retirement Accounts.
Advantages of Retirement Accounts
If you have signed up for a Retirement Account, you have probably heard all of this before. Employees and fund sales people are quick to talk about the fact that when you invest in a Retirement Account, you are investing pretax earnings, which often include employer matching funds. You are told that it is only through consistent saving in a Retirement Account that you will reach the nirvana of retirement. They like to show you charts that illustrate the magic of compounding.
Disadvantages of Retirement Accounts
This is the part you don't hear much about. One of the most glaring disadvantages of this type of investing is the limited selection of investment vehicles in the plan. Many employers offer only plans in which employees buy shares of that company's stock. You probably remember the childhood maxim about not putting all your eggs in one basket, don't you? But this is exactly what you are doing if you buy large amounts of stock in the company where you work. The road to retirement is littered with bodies from huge companies that failed, like Enron. Most employees who had invested in their Retirement Accounts walked away with nothing.
Or you may have an employer who offers you other options, such as buying mutual funds through two or three different fund families. A few mutual funds do really well, at least for a short period of time. But most mutual funds under perform the markets as a whole and have fees and charges for buying into and selling out of them. You are limited to stocks and bonds as investments. These investments often carry great risk. As an investor in a regulated account, you are not allowed to put your money into conservative investments such as certificates of deposit.
If you create your own account for retirement out of post tax money, you can invest in whatever you want with very small cost. You can buy shares in Exchange Traded Funds that mimic the performance of the overall market, so you will always be assured of doing as well as the overall market does. These shares can be had from a discount brokerage with one small charge of around ten dollars to put your money in, and another to get it out. No other fees or strings attached. That money is always there for you when you want or need it without penalties, restrictions, or the need to pay it back. You don't have to wait until you are 59 ½ to get it out.
If you are putting money into a retirement account now, you are doing it at a time when tax rates are at one of the lowest levels in decades. When you are ready to take your money out, you may face taxes at some of the highest levels in decades. This is just the reverse of what would be good for you. If you pay taxes on your money now when tax rates are low, what remains is yours forever no matter how high the tax rates go. The only taxes you will owe in the future will be on money that is generated by the money you invest. When you retire and want to take money out of what you have saved, it will be yours tax free.
If you can spend one hour a week or even one hour a month managing your own money, you will almost certainly do better than you would if you let someone else manage it, even if you have no training at all in money management. When you put your money in a Retirement Account, you are giving a total stranger complete control of it. That's like putting your health completely into your doctor's hands and expecting to be well. It just doesn't happen mainly because there is no reason for a hired fund manager to care as much about the outcome of your investments as you do. The fund manager cares about how his fancy footwork looks. If you lose money in the process, that's too bad.
If you buy some mutual funds in your Retirement Account that invest in stocks or bonds and the value of that investment declines, there is nothing you can do about it. Your money is gone and that's it. Not like in an account where you have placed already taxed money to save for your retirement. If you lose money in that type of account, you can deduct your entire loss from your income tax return over a period of time.
Suppose you want to leave money to your children. If you have saved after-tax money in an account and done well with it, the money transfers to your heirs with no income or capital gains taxes due. But if you are holding that money in a Retirement Account, tax is due on the entire amount when it transfers to your children, and this tax is at the ordinary income tax rate, even on amounts that would normally be taxed at the lower capital gains rate.
And getting back to the loan from your Retirement Account you may be thinking about. When you borrow this money, you will pay interest on your loan to yourself. This may sound like a good idea until you consider that you are repaying your loan and the interest on it with post tax dollars –- money you have already paid the taxes on. This is not like the deferred contributions you are supposed to make to such accounts.
If you borrow from your Retirement Account and are unable to repay it for whatever reason, the entire principal amount will immediately be subject to both federal and state income taxes. If you are under age 59 ½, the defaulted loan is counted as an early withdrawal from your Retirement Account, and you will have to pay a penalty of 10 percent on the entire principal amount. If you quit your current job or get fired, the remaining loan balance must be repaid within 60 to 90 days, or the loan is considered to be in default and the penalty is due.
So, who is it that really benefits from Retirement Accounts? Companies that are chosen for you to invest in by your employer probably benefit the most. T. Rowe Price is one mutual fund company frequently represented in employer sponsored retirement programs. Shares of stock in this company have appreciated in value more than 1000% since 1994, when Retirement Accounts really began to catch on. If you had invested post tax money in an account to save for your own retirement you could have bought shares in this company and gotten ready for a very comfortable future.
The earnings increases at T. Rowe Price that have fueled the advances in the share price came from the fees paid by people who invest in Retirement Accounts. But the people who own the mutual funds the company sells haven't done quite so well. Their return is comparable to a long term callable certificate of deposit which yields an annual return of about 6%.
The U.S. Treasury has done okay too with Retirement Accounts since your loses are not tax deductible as they would be in a regular account. And more taxes are paid at the death of you and your spouse as your money transfers to your children, who are taxed on the entire balance of the account at the rate of earned income.
Wall Street has done fairly well too from your Retirement Account, as your monthly purchase of stocks and bonds has kept transaction costs flowing to brokerages and exchanges. If you have put post tax money into your own account for retirement, you could have invested in companies like NYSE Euronext, the company that operates the New York Stock Exchange. Their shares are up more than 300% since 2004, based on fees generated by the trading of stocks in such vehicles as your mutual funds.
About the authorBarbara is a school psychologist, a published author in the area of personal finance, a breast cancer survivor using "alternative" treatments, a born existentialist, and a student of nature and all things natural.
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