Is Your 401(k) A Scam?

When you think of financial scams, you may think of Bernie Madoff and Nigerian Princes. But if you listen to enough “financial experts” on YouTube and TikTok, you may hear that the humble 401(k) is a scam.

A 401(k) is a tax-advantaged retirement investment account offered by many employers. It's an account so basic that it may be a victim of its own success. Has the 401(k) scammed aspiring retirees out of their hard-earned money?

We don’t think so, but we will explain why the account is being so harshly maligned.

What is a 401(k)?

A 401(k) is a tax-advantaged retirement account that employers offer to employees. Many companies offer an employer match to employees who contribute to the 401(k). For example, a company may offer a 50% match on all contributions up to 6% of your salary. If you earn $50,000, and you contribute $3,000 to your account, then the company will contribute an additional $1,500 to the account.

In a traditional 401(k), the money you contribute is tax-deferred. That means you get a tax deduction for the money you put into the account. The money grows tax-free until you withdraw money during retirement. When you withdraw money, you will pay your ordinary income tax rate on your withdrawals.

More companies are starting to offer a Roth version of the 401(k). When you make Roth contributions, you pay taxes before you contribute to the account (no immediate tax break), but you never pay taxes on that money again. Your withdrawals in retirement are tax free. 

As an employee, you can contribute up to $23,000 to your 401(k) in 2024. Your employer can contribute up to $46,000 to your account (but it probably won’t unless you’re a very high earner or self-employed).

The 401(k) is simply an account that holds money. But we will look at the reasons that some influencers call it a scam.

Related: 401(k) Contribution And Income Limits

What Do The 401k Scam Videos Actually Say?

Here's an example of the videos you'll see on TikTok and other social media:

We'll highlight the main counter points below, but when you see these accounts, you should also check at WHO is discussing this issue. In the case above, this individual is clearly a life insurance sales person and promotes IULs on his account. 

Why are IUL salespeople attacking your 401k or retirement plan? Because when you're young, there is a competition for dollars - you don't have enough money typically to contribute both to a 401k (or other investment like an IRA) AND contribute the money necessary to fund an IUL. 

So these individuals are trying to scare you that you're doing something bad, and that their product offering is better. But sadly, we've never seen a real example where it actually has performed better. 

Remember - these companies will show you "illustrations", not actual in-force policies. And none of them can show you an in-force IUL that's existing over 10 years. They're incredibly rare for a reason: they don't work as advertised for most Americans.

Your Money Is Locked Away

When influencers start attacking the 401(k), the first shot is predictably that the account “locks away your money.” Although this doesn’t mean the 401(k) is a scam, this claim is true. A 401(k) is a retirement account. You will pay a 10% penalty on any money you withdraw from the account before age 59 ½. So, when you withdraw money from your 401(k), you’ll pay income tax and the penalty on every dollar you withdraw.

A 401(k) isn’t an emergency fund, and it shouldn’t be used as one. If you don’t think that you can keep the money inside the account, you shouldn’t put it in the account in the first place.

Some companies allow you to take a loan against your 401(k), but we advise against that for several reasons. Your money won’t be invested while you borrow against it, so you lose time in the market. On top of that, if you separate from your job, you will probably need to repay the loan within 90 days (or sooner) or you’ll pay the 10% withdrawal penalty.

For the sake of comparison, most people who harp on your money being locked away are selling whole life insurance. You can’t “take money out” of a whole life insurance policy. Instead, you will borrow against the policy and repay yourself over time. The money in the policy is nearly as “locked up” as the money in a 401(k).

401(k) Fees Will Eat Up Your Returns

Plenty of people who hate on 401(k) plans point to excessive fees. This is one point that varies from plan to plan. Most large companies have low or no account management fees (I can say that my 401(k) account fee is $12 per year). Additionally, investment fees inside 401(k) plans tend to be modest (investment fees ranging from 0.1% to 0.3%).

But those maxims won’t always hold. Smaller companies or those with out-of-date 401(k) plans may have higher fees. If the only investment options inside your company’s 401(k) have investment fees of 1.5%-2.5% then you may want to think twice before investing in it (at least beyond your company’s match). Even with high fees, you’ll want to invest enough to get your company’s match or you’ll leave part of your compensation on the table.

The 401(k) Has Terrible Investment Options

Investment options inside 401(k) plans vary. The vast majority offer low-cost index funds or a handful of actively managed mutual funds. Some companies allow you to invest in individual stocks, but that is the exception rather than the rule. Unless you have a self-directed 401(k), your investment options will typically be quite limited. But that doesn’t mean the investment options are bad. You can maintain a well-diversified investment portfolio using the stock and bond funds that are available in most 401(k) plans.

Most people who call a 401(k) a scam because of the investment options have a vested interest in getting you to invest in an esoteric or high-cost investment. They may encourage leverage, private REITs with high fees, high-frequency trading, or whole-life insurance. Many of these investments are good. You may benefit from some exposure to real estate, precious metals, or other alternative investments. But you can get that exposure in addition to your 401(k), not instead of.

You may see higher returns by investing in alternative asset classes, but that doesn’t detract from the value of stock and bond funds. Most 401(k) plans offer simple, tested investment options that can help the average person build wealth over time. Alternative investments, especially those that involve leverage (debt) are risky, and they could erode your wealth just as easily as they could build it.

Your 401(k) Traps You In Your Job

Some companies have vesting schedules with their 401(k). A vesting schedule means that an employee must stick with the company for a certain time before they get to keep their employer’s 401(k) contributions. A company can have a cliff vesting schedule where they require employees to wait up to three years before they take ownership of the company’s 401(k) contributions. Companies can also have a graded vesting schedule where you take ownership of a portion of the company’s 401(k) contributions over up to six years.

The vesting rules may be an incentive to stick at a company longer than you otherwise would have, but they certainly don’t trap you in your job. Any money that you contribute to a 401(k) is your money, and you can keep it when you move jobs. When you move jobs, you can either roll the money into your new 401(k) or roll it into an IRA.

You Have To Pay Taxes on Your 401(k)

A traditional 401(k) contribution is a tax-deferred contribution. You won’t pay taxes when you put money in, and you won’t pay taxes on your investments as they grow. However, you will pay your ordinary income tax rate when you take money out.

Income tax rates are already higher than capital gains tax rates, and income tax rates may increase in the future. When you take money out of your 401(k) in retirement, you may end up paying high tax rates on those withdrawals.

Given the historically low tax environment that we’re currently in, you may want to consider a Roth 401(k) option if it's available to you. If you use a Roth 401(k), you’ll pay income tax on the money now. But the money will grow tax-free. And when you withdraw the money, you won’t have to pay taxes on the withdrawals.

Many slippery salespeople will try to get you to buy whole life insurance by saying it is more tax-efficient than a 401(k). The value of cash value life insurance indeed grows without taxation. What’s more, if you cash out your life insurance policy, you will only pay capital gains taxes, not income taxes. However, you don’t get a tax break when you put money into a whole life insurance policy. That means that you pay income taxes before you pay for the life insurance, and you pay capital gains on the growth if you cash out the policy.

The tax question is complex. A fiduciary financial planner could help you figure out whether to invest in a traditional or Roth 401(k). Either way, a financial planner who is looking out for your best interest will rarely recommend a life insurance product instead of a 401(k) contribution.

Should You Invest in a 401(k)?

If your company offers a 401(k), please invest in your 401(k) up to the match at least. You don’t want to leave that money on the table. After that follow the order of operations for saving for retirement. A 401(k) isn’t a scam. It’s a tax loophole that you can use to your advantage. The 401(k) can help you invest your money in a tax-efficient way, so you can grow wealth over the long term.