Adam’s Blog

That’s my thing, keepin’ the faith, baby. –Joe Friday

401 (k) v. Savings

Posted by Adam Graham on February 3, 2007

I rarely talk finance on my blog (despite working in the financial industry) but reading Don Surber’s latest post forces me to induldge in corrective assistance. Surber opines:

Martin Crutsinger of the AP scored big on the Bush administration with a deceptive story about the nation’s savings rate.

After-tax savings rate, that is.

The rate that does not include the $3.2 trillion Americans have socked away in 401 Ks and other pre-tax savings plans.

Now, I don’t know what the current administration has to do with our savings rate. That tends to be a matter of personal economics, not the President’s decision. You could make Nancy Pelosi President, or whoever you like and it’s not going to change over night.

But Surber’s basic problem is that 401(k) money is savings for retirement. It’s not a substitute for a savings account.

The money in your 401(k) or IRA has to last you through decades of retirement. The government understands this, which is why putting money into these plans is generally a tax plus but removing them before age 55 (or 59 1/2 depending on the plan) will cost you through the nose.

Myself and some other folks with understanding of how this stuff works have made posts on a thread dominated by people who’d rather be seen as defending the President no matter how silly they have to get to defend what is itself a silly implication. One person said, “Investments aren’t savings.” to which someone replied:

So where ARE my savings? If I put my ’savings’ in a mutual fund are they no longer ’savings’? Hopefully, yours are not buried in the back yard.

This questions requires that we basically define our terms.

Savings=This is money that is available for you. Savings can be the rainy day fund. It can be the money you put aside for a vacation. It’s something that’s liquid and that you’re able to use easily.

Investments=An investment is something that you’re purchasing because it will increase in value over time. Real estate, stocks, etc. can be investments. Investments may have ups or downs, but over the long term good investments will go up.

Why aren’t your investments the same as your savings? Because Savings for whatever purpose is dependable, an investment is not. A mutual fund I’m going to buy has a 20 year track record with an average annual return of 14%. It also had a couple years, where it lost money, but I’m buying it as an Investment for an IRA as I don’t plan on retiring anytime soon, the ups and downs should more than balance out based on the track record.

However, if I go and put my savings into a mutual fund, say I’m buying a house in 6 months, my mutual fund may take a slide at the exact wrong moment, meaning I don’t have enough for a down payment.

Thus, a good financial plan includes Savings (stable, available money) and Investments (variable money that will grow over time but can’t be tapped easily.) If I have no savings and all investments, than what will happen to me is that I’ll begin to tap into my investments. Not only will I pay a high price if I tap into a Retirement account (in terms of taxes and fees) but I’m losing all the potential growth I’d get out of that money if I’d left it in the account. If I have all savings and no investments, then my money will never grow.

To treat an investment as savings or a savings as an investment is to create a headache. One person argued my point on the 401(k):

If your company matches your 401k savings deposits by at least 25% then it is in fact better to put money in your 401k and then take it out with the penalty as opposed to putting it into after-tax savings. If there is ANY rate of return on that money its a complete no-brainer (even assuming the same rate on the savings and 401k). This point is more true the higher the taxes you would pay.

And at the same point, you utterly destroy your 401 (k) plan and ruin your retirement. If we look at the 401 (k) as a big savings account to withdrawal at will, we’ll never leave enough in there for retirement. Treating it as a savings account, you’re almost sure to pull out too much money.

As a result of pulling out too much money, you not only lose the tax penalty, you also lose all the money that the funds in your 401 (k) would earn you for your retirement. If I leave $10,000 in a 401 (k) earning at 10% interest (quite reasonable by Stock Market standards) and I leave it alone, in 20 years, I’ll have nearly $70,000. By taking $10,000 out of your 401 (k) to pay for a vacation or emergency, you cost yourself $60,000 or more if you’re further out from retirement.

In addition to this, most work places don’t continue a match on for infinity. A former employer would match 50% of what you put in up to 3% of your before tax pay. In such a situation, even if you divided the 401 (k) in some way between what you saved for retirement and what was blow money for whatever thing you wanted, you would still be saving far too little for retirement and for general savings.

This is the worst advice imaginable that’s being propogated by folks. Think long term, yes have 401 (k)s, IRAs, and all that retirement stuff. Have a good savings account, so that you’re not tempted to touch those funds in any situation other than the most dire emergency.

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