Sep 18

Have I lost my marbles? I hope not. Let me explain by starting with an analogy.
There’s a difference between treasure and a treasure chest. It’s not just a pedantic picking apart of words. Not understanding the  distinction is costing people a lot of money.

A 401(k) is a retirement account typically sponsored by an employer, although there is also a solo-401(k) option that self employed individuals can take advantage of. Until 2006, the 401(k) was strictly a pretax account, deposits from the employee would be deposited and save the tax at the time, grow tax deferred until retirement and withdrawn at (potentially) a lower tax rate. Employers’ matching deposits are also pretax and taxed on withdrawal. In 2006 the Roth 401(k) was introduced, allowing deposits to be made post tax, with the growth tax free if withdrawn after 59-1/2 or after separation from your employer after age 55.

treasure-chest

This is a high level overview but you see what’s missing? The Investment. I’ve only described the nature of the account, not the investments it contains. A 401(k) can have a variety of choices of investments. You may pick from a money market fund, short term bond fund, various stock funds including domestic and international. Some even allow you to shift funds to a broker portal where you can invest as you wish in individual stocks.

The distinction here is that the risk or reward has little to do with the 401(k) per se, and everything to do with how you choose to invest. In fact, you can made the same good or bad decisions in a regular brokerage account as you can in a 401(k).

This is my long-winded way of saying not to let the market volatility scare you out of proper long term retirement investing. I’ve had dialog with people who choose prepaying their 5% mortgage over making a matched 401(k) deposit, and when I point out the instant 100%  gain they can see in their retirement account, I hear they’d prefer the certainty of the 5%/yr interest saved over the risk their retirement account loses half its value as it did in the months leading up to March, 2009. The flaw in their reasoning is twofold. First, as I discussed, they need not be fully invested in stocks. The litmus test for how much of your account you should allocate to stock is to answer the question – If the market fell 50% over the next year, how would you react? If the answer is to sell at the bottom, you are too high in stocks. Second, your investments aren’t made all at once, but over decades. When you are buying into the market with each paycheck, your average cost is the average not last week or year, but the average over the last decade or more. And hopefully your sale price isn’t at the next bottom, but a few percent each year starting decades from now.

written by Joe \\ tags: ,

2 Responses to “A 401(k) is not an investment”

  1. Quizzle Top 5 Weekly Must-Reads – September 22, 2013 | Quizzle.com Blog Says:

    […] A 401(k) is not an investment Joe Taxpayer asks his readers if he has lost his marbles because of his statement that a 401k is not an investment. […]

  2. What I've Been Reading, Week 40 - Feeling Financial Says:

    […] like the title says: a 401k is not an investment. It’s a thing you might invest inside […]

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