The Good, Bad & Ugly News on 401(k) Investing

401(k) investment plans remain one of the best ways for Americans who are living well into their 70s and 80s to afford retirement. After all, Generation X and Millennial workers won’t be able to count on the same retirement-age benefits as Baby Boomers are enjoying now.

Case in point: Social Security (SS) is now entirely dependent on deficit spending. Don’t believe the old canard about the SS trust fund running dry by 2034. The government first started to “borrow” SS funds to pay for welfare programs and the war in Vietnam in the late 1960s. After decades of borrowing from Peter to pay Paul, there’s no cash left in the SS trust.

Congress and the White House show no signs of shutting off the spending spigot. Which means “hotter than expected” inflation (as every media outlet seemingly describes the recent surge in prices) isn’t going away anytime soon. And as the national debt grows by $1 trillion every 100 days, it’s going to get worse before it gets better.

Bottom line: Americans in their 30s, 40s and 50s shouldn’t count on collecting similar Social Security benefits in real dollar value as Boomers are. They’ll need to count on themselves to afford to live once they’re not working full-time.

Believe it or not, that’s not the ugly angle 401(k) investors need to know about! We’ll get to that part a little further down in this report. But first, let’s focus on the good news:

Workers’ 401(k) wealth is on the rise

2023 was a better year for retirement plan holders than 2022. The bull stock market certainly helped lift all boats, but let’s give credit to workers for socking away more for their golden years. Case in point: Generation Z (aka Zoomers) are putting 20% of their pay into retirement funds, significantly more than older generations are, though they’re not as bullish on the 401(k).

Vanguard reports that its average 401(k) balance rose from $112K in December 2022 to $134K by the end of 2023. 401(k) plan holders are nearly back to where they stood in late 2021 when the average account reached an all-time high of $141K.

More good news: Fidelity Investments saw a 20% jump in 401(k) millionaires from September to December 2023. About 422,000 Fidelity 401(k) accounts are currently worth $1 million or higher. While stock market value gains over time are driving 401(k) wealth, there are three factors entirely within employees’ control:

1. taking advantage of the employee match, and
2. increasing one’s percentage of annual income to a 401(k) whenever possible.

Now for the bad news …

The third factor — not listed above — is, of course, refraining from taking early withdrawals. Taking money out of a 401(k) before one turns 59 1/2 results in:

• the IRS imposing a 10% early withdrawal penalty
• additional income being subject to income tax owed the following year, and
• slashing future wealth that’s very hard to replace.

Most employees aren’t aware of the power of compounding interest when it comes to retirement savings. “For example, withdrawing $20K early will cost you a fortune,” warns Breitbart‘s John Nolte. “At an annual 5% interest rate, that $20K will be worth $54K in just 20 years. … [and keep in mind the] stock market historically does much better than 5% over the long term.”

But alas, more Americans are increasingly tapping their 401(k) despite the penalties. “A record share of 401(k) account holders took early withdrawals from their accounts last year for financial emergencies, according to internal data from Vanguard Group,” notes the Wall Street Journal. “Overall 3.6% of [Vanguard] plan participants did so last year, up from 2.8% in 2022.”

Congress eliminated some hurdles to taking a hardship distribution, including a requirement that an account holder apply for a 401(k) loan first. About 40% of folks who made early withdrawals in 2023 did so to avoid a home foreclosure, according to Vanguard. At least three-quarters of hardship distributions were for $5K or less.

It’s getting ugly out there

Debt and inflation is pressuring workers to seek funds to pay bills and debts wherever they can. Americans are carrying more credit card debt than ever. People are increasingly late to pay credit card bills, auto loans and rent.

The pause on student loans ran out last fall. Foreclosures and evictions are up, and bankruptcies are on the rise. Some folks are declaring bankruptcy for the second time, leaving credit & collections department scrambling to recover debts.

In the meantime, President Biden is calling for a higher corporate tax rate and the elimination of tax breaks for wealthy individuals and corporations to pay for government spending. Most if not all his proposals will require Democrats controlling both chambers of Congress, or Republicans agreeing to hike taxes, if he wins re-election in November.

Biden’s budget plan also includes capital gains tax increases. For example, “Biden is proposing to increase the 3.8% Medicare tax to 5% for those earning at least $400,000 to shore up the [Medicare] program’s trust fund,” reports Bloomberg. “That would mean the richest taxpayers would pay a 44.6% federal rate on investment income and other earnings.”

For now, Biden and Congress aren’t broaching the possibility of taxing Americans’ 401(k), IRA and other retirement savings — at least not yet, and certainly not in public. American workers hold close to $10 trillion in employer-based retirement plans, nearly two-thirds of that bounty tied up in 401(k) plans.

One thing’s for sure: Unless lawmakers finally take a hatchet to government programs and stop spending into oblivion, Uncle Sam will consider every possible source of tax revenue. And that includes taking a bigger piece out of American workers’ savings.