401k scam or not? Taking the plunge..

[Andrey Y.]

I have never been a big fan of 401k and retirement accounts in general that are invested in mutual funds. I have always thought of it as a "life deferral plan", you put money in, that is money that is lost from your life, does not pay you every month, poof gone.

Plus, most people have no idea what they are investing in. I love real estate precisely because of the control it gives me, and the monthly income. My RE investments already cover my basic monthly income.

However, after researching mutual funds for the last 6 months, and getting a lot of feedback, I decided to start contributing again to the TSP/401k. Every single physician colleague I have talked to, basically said I should be doing it as a way to lower taxable income, and diversify into a different class. The argument is, if you are a high income earner, it would be easy to contribute to a 401k/IRA and invest in real estate.

So against my better judgement, I have decided to take about $15K out of my last 3 paychecks of 2017 to fund the TSP. My real estate has returned 20-30% IRR since 2013, yet I am sitting trying to diversify a little into equities.

I wanted to know what you guys think: about 401k in general, my situation, and your own situation. Is it really a scam? If I wanted to retire around 40yo, are my funds in retirement accounts "stuck? I still see it as 'lost money' that I don't get to spend now, but enough clinical colleagues have convinced me to do it.

[Brian Eastman]

@Andrey Y.

A 401k retirement plan is certainly not a scam.  It is a powerful vehicle for building future wealth.

When you contribute to a 401k or TSP style plan, you benefit in 3 ways:

1) in some cases you may receive an employer match.  This is free money or a 100% return on investment, depending on how you want to look at that.

2) You receive a tax deduction for the income contributed in the year in which you make the contribution, reducing your tax bill.  This is also effectively a return on investment on the money you contribute equal to your combined state & federal tax rate.

3) By contributing to the plan, you also reduce your overall taxable income, which may drop your tax bracket on the money you do pay income tax on.

So, on the front end, lots of positives.

Investment choices in many conventional retirement plans are limited.  That is a potential negative.  That said, even a moderate return compounded over time can add up significantly.

Earnings to the plan are tax sheltered.  So, instead of diluting your return with taxation, you are accelerating the rate at which your money compounds.

Money in a qualified retirement plan will be locked up until you are 59 1/2, at which point you can begin to take distributions.  The idea is that by deferring the taxation up front and on the earnings over time, you can balloon a small amount of annual contributions each year into a large sum from which you can support yourself in your retirement years once you have stopped working.

This is, of course an oversimplified version, but should clearly illustrate the benefits of tax-deferred retirement savings.

You can add to the above the ability to make contributions on a Roth basis and create tax-free income, as well as the ability once you change jobs to move an employer retirement 401k or TSP to a self-directed plan where you can invest those tax-sheltered dollars in things like real estate.

If you are a physician, I would assume you create reasonably significant income, even if you work for the government.   I strongly suggest that you have a sit down with an independent financial advisor and/or tax strategist.  I'm talking about a financial consultant, not a stock salesperson.  You can chart a path that includes a mix of conventional retirement plan and outside investments such as real estate, and create multiple sources of income with different tax exposures.