Are There New Misconceptions of the 401(k)?

There may be new 401(k) myths on the horizon, if President Obama gets his way with the tax-qualified retirement accounts of Americans. When the President revealed his 2016 fiscal year budget, it included a proposal to place a limit on the amount of money workers can contribute to their tax-favored retirement accounts; this includes their IRAs, 401(k) accounts and private pensions. The plan comes on the heels of a proposal to start taxing 529 college savings accounts, an idea that was met with so much blowback from both the left and the right that the White House ultimately decided against going through with it. Unfortunately, the equally bad idea of limiting the amount that people can contribute to their retirement accounts still remains on the President’s agenda. But why?

Perhaps it’s because of public misinformation. There is a widely held belief that any policy placing restrictions on investments is designed to hurt only the wealthiest Americans – the so-called “one percent.” In fact, one of the many misconceptions of the 401(k) floating around is that it is only available to high earners. If you are a middle class earner with a 401(k), you know that isn’t true. If a policy that limits how much workers can contribute to their 401(k) accounts comes to fruition, it would actually hurt the middle class more than anyone else. Allow us to illustrate.

Two Problems with the Proposal 
The president’s proposal would place the cap on these tax-qualified retirement accounts at $3.4 million for a married couple. In other words, a couple could not amass more than $3.4 million in their portfolio – which, according to WhiteHouse.gov, would give them an annual retirement income of $210,000 from that account. There are two things wrong with this, starting with the fact that White House is giving us this figure because the administration believes that $210,000 in annual income is the point at which one becomes “rich.” That’s the first problem.

The second problem is that $210,000 is not even the correct number here. It is not the amount that can be expected or derived from a $3.4 million retirement account, even by very generous financial planning guidelines. The fact is, a couple earning $210,000 from a $3.4 million portfolio is withdrawing a very risky 6.2 percent per year. That’s quite a bit higher than the already dangerous 4 percent withdrawal rate that is more commonly recommended. Anyone who withdraws 6.2 percent per year will almost surely run out of money before they die. If you withdraw 4 percent per year, that would not result in an annual income of $210,000; instead, it would result in an annual income of $136,000 – but only if the portfolio contains $3.4 million.

Withdrawal Rate and Misconceptions of the 401(k)
Hypothetically, what if you and your spouse have a more realistic amount in retirement savings, like the current average 401(k) balance of $91,300? If you withdraw the White House’s 6.2 percent per year from a $91,300 account, that account gives you $5,660.60 per year in retirement income. If you withdraw the recommended 4 percent per year, that account only gives you $3,652 in retirement income. Either way, there’s a 61 percent failure rate, which means there’s a 61 percent chance you will run out of money from the account before you die.

A financial advisor who understand the risks involved would recommend withdrawing no more than 3.5 percent per year. For a $91,300 retirement account, that produces $3,195 in annual retirement income. Although that seems low, it’s a better deal because it has a failure rate of only 3 percent. In other words, they can depend on that income to be there for the rest of their lives, and they can supplement it with other sound investments with the help of their financial advisor.

Just like Social Security before them, IRA and 401(k) accounts are subject to rule changes that the government assured us wouldn’t happen. Decades ago, Americans believed their Social Security accounts had minimal tax implications – but in 2015, as much as 85 percent of Social Security income can be taxed. In 1978, Americans were told 401(k) accounts were a tax-favored alternative to living on Social Security – and now, that is on its way to becoming one of the growing misconceptions of the 401(k).

These concepts were derived under current laws and regulations. Changes in the law or regulations may affect the information provided.

All numeric examples and any individuals shown are hypothetical and were used for explanatory purposes only. Actual results may vary.