As soon as I posted my article about flaws of 401k and why I stopped contributing to it I had a reader telling me that I forgot about 3% – 4% employer match which is free money.
It is a good point from him and although I replied to him in the comments, I decided to re-post my response as a separate post.
Originally, I didn’t include the match because I consider it insignificant and with no benefits to anyone to sway one’s mind and invest into the 401k “ignorance” plan.
Many used the employer match card as the most significant benefit and that you shouldn’t leave the free money on the table.
But in fact, the free money is just luring you into a trap from which there will be no escape. There will be no escape for the next 20, 25, 30, or 35 years (unless you change job and convert the 401k into a self directed plan such as IRA or ROTH IRA). But even after that period of time, at the very end, when you start withdrawing money, you will be punished for your ignorance and pay dearly for that “free money”.
The question is, is it really free money? And what are you giving up to get the free money? Is it worth it?
In my opinion, the answer is a resolute NO.
Let’s take a look at a few flaws of the free money.
· 4% employer match
Let’s establish some base point before we proceed.
In my previous post Why I stopped contributing to 401k I wrote that in order to meet the savings rate of what the financial industry is telling us to have to retire comfortably a young person, fresh from college at 27 years of age and gross salary of $55,000 per year must be saving almost 19% of his salary to meet the goal.
That means, he or she would have to save $800 every month or $400 bi-weekly.
On top of that, your employer will provide you with 4% match of free money.
That “free money” will be ~ $84 bi-weekly.
($55,000 / 0.04 / 52 = $42 weekly match * 2 = $84 bi-weekly match)
· Is it worth it?
Is it still all worth $84 every two weeks to offset all negatives of the 401k when participating in the defined contribution plan?
Let’s take a look at some numbers then.
The “free money” may look nice when you are just starting your 401k, but once you save and invest 30 thousand dollars or more, this “free money” will never be able to offset benefits of your own investing or trading (for example dividends).
Once you will be able to buy at least 1000 shares of dividend growth stocks, with initial 3% dividend yield, dividend growth 3%, then after 10 years your YOC will be almost 6% and your dividend income $158/mo which matches the “free money”.
Look at the table below for the growth of your account and dividend income if you reinvest the dividends:
|Year||Income||Yield on Cost||Account Value|
Data used for calculations:
Starting yield: 3%
Dividend growth: 3%
Shares held: 1,000
Cost per share: $30.00
Years to hold: 10
If you buy 1000 shares and reinvest your dividends, your account will grow to $42,068.21 just on the dividends (add to it capital gains!) which is 4.02% dividend annual gain. Your yield on cost will increase from 3% to 5.28%.
Your annual dividend income will almost match the “free money”. And this example doesn’t take into account your continued contributions which will make your account growing even faster.
Imagine what I can do with the money when trading options and making 10% monthly (which is what I currently make)!
And here it is what your account would look like 30 years later:
|Year||Income||Yield on Cost||Account Value|
Again, the calculations above do not take into account additional contributions. It only shows compounding of reinvested dividends on a one time investment of $30,000 dollars invested in a high quality dividend growth stock and quite conservative yield and dividend growth.
If you add additional contributions, mix of other dividend stock (so your initial yield would average closer to 5% than 3%), and capital gains of your stocks, then the numbers above will be even higher.
Below is an extrapolation of my own account. My account is yielding 5% and dividend growth rate is 9.44%.
My portfolio in the next 25 years:
(my retirement eligibility; quarterly dividend compounding)
My dividend portfolio, which is currently worth $21,000 dollars +/- and yields 5% at 9% dividend growth is basically set to provide me with enough income in the future.
Even if I contribute zero dollars from now on and just maintain the existing stocks in the portfolio I will end up with $906,996.63 dollars annual income (in today’s dollars) from dividends alone.
Do you still think it is worth investing into 401k because of the “free money”? Will your 401k be ever able to provide you dividend income matching that one of my existing portfolio?
Just for comparison, my 401k plan, currently worth $80,000.00 made $1,438.75 dividend income. My own ROTH IRA worth $21,000.00 brought in $883.48 in dividends.
My 401k plan, with all the free money, under-performed income of my ROTH IRA by staggering 42%!
Do you still believe, it is worth it to lock your money for the next 30 years in a lousy 401k because of free money?
· More punishment for free money ignorance
If you still think it is worth to invest into 401k because of free money, let’s review what’s awaiting you at the end of the savings cycle when you reach the retirement phase and start withdrawing money.
If we compare our own self-built dividend growth portfolio vs. 401k plan withdrawals rules what it would look like?
Taxes and death.
Dividend growth portfolio (in IRA, or taxable account)
In my own dividend portfolio I will be withdrawing dividends ($75,583 monthly in today’s dollars, $906,996.63 annual dividends income; see table above).
I will not be required to sell a single stock in my portfolio. Thus if in IRA or taxable account, I will not be required to pay any capital gain taxes. If in a taxable account, will only pay 15% tax on qualified dividends. With my ROTH IRA, I will pay nothing.
If we happen to be in the middle of the crisis or panic selling you do not need to worry about the value of your portfolio. All you will be looking at is your never ending, intact, dividend income. Your income will still be safe (you just need to watch for the companies to keep paying dividends. Most of the companies in my portfolio raised dividends during 2008 crisis!
With 401k plan, in order to get income or withdraw cash from the plan, you will have to sell your shares of mutual funds. The mutual funds do not generate cash which would be readily available for withdrawal. Any distribution or dividends are immediately re-invested and there is no option to stop this reinvestment.
You will have to sell.
And what if there will be a financial crisis and you will have to sell when everybody is panicking?
And even if you will be selling on top of the bull market, your withdrawal will be taxed as an ordinary income. And good luck getting below 25% bracket with no exemptions available.
Are you still convinced it is worth the “free money” of $84 bi-weekly?
· The “free money” lure is still not worth it
For this initial insignificant boost of “free money” I am not going to block my savings for 30 or more years when I can achieve more than that as my calculations above indicate.
Everybody can do the same! Investing into dividend growth stocks is not difficult and not a rocket science. As I said before, if you can buy bread in a grocery store, you can buy dividend stocks. It is that simple.
Do not let the financial industry involved in providing and managing 401k plans robbing you your own money.
For example, from 1995 to 2008 the Fidelity Magellan Fund charged its clients $4.8 billion of dollars in fees! That’s $369 million dollars every year of YOUR money! The entire industry fee revenue was $88 billion dollars in 2015, up 76% from 10 years ago. (Source: “2015 Fee Study: Investors are Driving Expense Ratios Down”, Morningstar, 2015).
Let me ask you a question. What does it take to manage a mutual fund which would cost $4.8 billion dollars which you cannot do on your own for yourself?
All my calculations above were based on a one time investment of 1000 shares at $36 a share, initial dividend yield 3%, and dividend growth 3%.
I acknowledge that in the first few years the investing dynamic may not be any better than 401k or as shown in my calculations since a young person starting his/her savings will not be able to come up with $36,000 dollars immediately (which is a case for mutual funds too), so additional “free money” contribution match may be helpful.
However, at a savings rate of $800 monthly, it would only take 4 years to save enough money when the income from dividends greatly exceeds the mediocre benefits of 401k and free money addition.
Hope this helps to show flaws of luring people into 401k by providing “free money” which actually are not free at all.
In the end, you will pay for that free money dearly by lost opportunity and fees!