Why You Should Stop Contributing to Your 401k and IRA Today
One of the biggest mistakes I see many young people make is that they still contribute to a 401k or IRA. These tax deferred retirement accounts are outdated and bad tools for accumulating wealth. In fact, I would argue they are the worst way to build wealth.
As a tax planner, it makes my job really difficult when a new client comes to me with a bunch of money saved inside a 401k or IRA. There is virtually nothing you can do in a tax efficient manner to get that money out, use it, and pass it on to your children without paying a big chunk of your savings to Uncle Sam.
My goal is to help you understand why these plans are terrible tools for building wealth. Yes there are many financial advisors, tax professionals, wealth planners, and other professionals who will disagree with me. But the simple fact is – wealthy people do not use 401ks or IRAs.
Please note that we are not financial advisors or registered investment advisors. We do not give investment advice and encourage you to do your own independent research and seek the assistance of qualified individuals where necessary before making any investment decisions.
What are 401ks and IRAs?
I will spare you the boring history of retirement plans. However, in short, 401ks and IRAs are tax deferred retirement plans created by the government to help encourage individuals to save for their retirement.
Because the plans are tax deferred, that means you don’t pay tax on the money you contribute to the 401k or IRA now. Rather, you pay tax in the future when you take distributions out of the plan.
There are limitations on how much you can contribute and you typically cannot take money out of the plans until you hit retirement age without incurring a large penalty.
As a basic matter, 401ks are used when you work for a company and are set up by your employer. When you work at a large company, you are commonly able to participate in that company’s 401k plan. IRAs are more frequently used in the context of small business owners or freelancers. In some situations, you can set up your own IRA and manage it yourself.
The idea that I work until I turn 65, retire, and stop making money is outdated.
The entire strategy behind using these plans is that I make more money when I am working and make less money when I retire. The idea that I work until I turn 65, retire, and stop making money is outdated. Building wealth means building different streams of income now that will persist throughout your life. If you do this properly, you should be making a heck of a lot more money (albeit passively) when you are 65 than you do today.
What is the Difference Between a Traditional IRA and Roth-IRA?
You may have heard of a Roth-IRA, which works a bit differently from a traditional IRA. With a Roth-IRA, you pay tax on the money you contribute now; however, you do not pay tax on distributions from the plan. That means once you hit retirement age, you can take out the money saved in the Roth-IRA, including any gains the money has made over time, without paying any tax.
Roth-IRAs are more preferable to traditional IRAs and 401ks and something the wealthy use quite frequently. You may have heard about the ProPublica article detailing how Peter Thiel, the co-founder of Paypal, has accumulated over $5B in his Roth-IRA. That means, unless Congress acts to change the current laws, he can take out that $5B without paying any tax on the money.
It is worth noting here that you never read any articles about wealthy people like Peter Thiel having billions stashed away in a 401k or IRA. That’s because they don’t use these plans.
The main issue with Roth-IRAs is that there are limitations on who can contribute. In 2022, if you make above $144,000 ($214,000 for married filing jointly) you are not able to make contributions to a Roth-IRA. This means wealthy individuals are always prohibited from directly contributing money to a Roth-IRA.
There are also limitations on how much you can contribute. As of 2022, you are generally only permitted to contribute $6,000 to a Roth-IRA each year. That isn’t a lot of money.
However, even with the limitations mentioned above, there are ways to get money into a Roth-IRA by doing what is called a back-door Roth-IRA conversion.
Pay attention to any potential law changes on this as some in Congress have indicated a desire to prohibit the ultra-wealthy from using these plans in the future.
Why Does My CPA Tell Me to Max Out My Contributions?
The simple answer is that your CPA is wrong. The biggest problem with the accounting industry is that CPAs and tax professionals focus on putting numbers into boxes on a form to file your tax return rather than real tax planning strategies that can help you reduce your taxes.
One way to tell if you are working with a bad CPA or tax advisor is their “tax planning advice” (or lack thereof) is to max out your contributions to your 401k or IRA. The most common conversation with new potential clients for my tax consulting business goes a little something like this:
Me: What tax planning have you done in the past?
New Client: My CPA just always told me to max out my contributions to my 401k.
I always feel bad every time this happens because it is such bad advice. I consider it one of my personal missions in life to educate everyone on how bad and outdated these plans are.
If your CPA tells you to keep using your 401k or IRA, I would head for the door and never turn back.
6 Reasons to Stop Contributing to Your 401k or IRA
1. They Don’t Reduce Your Taxes
As mentioned above, the outdated thinking on these plans is as follows:
I make more money now than I will when I retire because I get paid a salary now and won’t when I quit working.
Because I make more money now, I am in a higher tax bracket than I will be when I retire and make less money.
It is better to defer paying tax now when I am in a higher tax bracket than later when I am in a lower tax bracket.
This idea is based on 2 key assumptions: 1. You make more money now than you will when you retire and 2. You will be in a lower tax bracket when you retire.
Both of these assumptions are faulty at best.
First, why would you ever entertain a wealth planning strategy that is based on the idea that you make more money now than you will in the future? Why would you ever plan to make less money in the future? I have never understood why this strategy makes any sense.
If you make more money in your 30’s and 40’s than you do in your late 60’s and 70’s, you didn’t do something right. And you definitely didn’t use a sustainable wealth building strategy.
Second, are you really comfortable betting on the fact that you will be in a lower tax bracket when you retire? All else equal, if the tax rate you pay today is the exact same as what you pay when you retire, you break even as far as using a 401k or IRA as opposed to a Roth-IRA. That means you will pay the same tax and have the same amount of money in your pocket with all of these plans if the tax rates are the same. However, if the rates go up after you start taking distributions, even by as little as 1%, you would have been better off using a Roth-IRA.
Many fail to understand that current tax rates are at historic lows in modern-day history. After the Trump tax cuts, tax rates are about as low as they have been in the last 90 years. Another point that often gets overlooked is that the rate reductions put in place by Trump will automatically expire in 2026. That means tax rates are certain to increase in 2026 unless Congress acts, which I think we can all agree is unlikely to happen.
Another sad reality is we know the national debt is increasing at an unsustainable pace and we know Social Security is a mess. I’ve never been a betting person but if I was, I would make a huge bet that rates will go up and not down in the future. Some are even predicting tax rates could double in the near future!
Why would you ever entertain a wealth planning strategy that is based on the idea that you make more money now than you will in the future?
2. You Have No Control Over Distributions
These plans have mandatory distribution requirements. That means when you hit a certain age, you are required to take out a certain amount of money from your 401k or IRA or potentially face big penalties.
Because of this, you have no control over what you have to take out of these plans. When you have no control over how much you are required to take out, that means you have no control over what your taxable income will be each year.
3. You Can’t Access it Now
Money I have saved that I can’t access for several years until I retire is virtually worthless to me. In order to employ efficient wealth building tools, I need to have access to that money today, not 30 years from now when I retire and can finally start taking distributions (taxable distributions at that) from my plan.
4. Limitations on How You Can Invest
Similar to not being able to access the money, there are significant limitations on how you can invest the money inside your 401k or IRA. As a practical matter, you are basically limited to investing in the stock market, or dare I say it, mutual funds (aka the worst type of investment you can make).
5. Lack of Predictability
If I ask you how much money you have saved in your 401k or IRA, the only correct answer to that question is – I don’t know. The truth is, you have no clue how much money is inside your retirement plan.
The truth is, you have no clue how much money is inside your retirement plan.
How can you properly plan how much money you have saved and what you will need after you retire when you have no clue how much money in your 401k or IRA is actually yours to keep?
6. They Are The Worst Way to Pass Down Wealth to Your Heirs
Please read this carefully as this is a detail that often gets overlooked by attorneys, CPAs, financial planners, and anyone else who has a say so on what you do with your money. 401ks and IRAs are the worst way to pass down money to your heirs. From an estate planning and tax perspective, having money inside a 401k or IRA when you die is extremely inefficient.
401ks and IRAs are the worst way to pass down money to your heirs.
The Right Way to Use a 401k or IRA
Even with all the disadvantages of 401ks and IRAs, there are still some situations where it might make sense to contribute to a tax deferred retirement plan.
1. Your Employer Provides Matching
If your employer provides matching, that is free money. You never want to turn away free money. So if your company provides matching, you should contribute up to the matching, but stop there!
2. Lever to Reduce Your Tax Bracket or Taxable Income
In some cases, you can use contributions to a 401k or IRA as a lever to kick you down to a lower tax bracket or keep you below a taxable income threshold. Sometimes I use these levers with my clients if, after modeling, it is clear that there will be significant tax savings by being in a lower tax bracket or slightly reducing taxable income.
This is not very common and often the tax savings may not be worth the trouble of setting up and maintaining the retirement plan. Nevertheless, any good tax planner will always have this in their repertoire of potential tax mitigation strategies.
The simple fact is – wealthy people do not use 401ks or IRAs.
There Are Better Tools Available to You
The key is making sure you educate yourself on these strategies and work with the right advisors. It might be time to upgrade your tax advisor or fire that financial planner who isn’t giving you good advice. Whatever you do, make sure you don’t make the same mistakes our parents and grandparents did by having all your money saved inside a 401k or IRA!