Saving for retirement is a crucial part of financial planning, and the earlier you start, the better.

Unfortunately, a lot of people are putting themselves into a precarious situation by depending solely on Social Security. This is not a wise strategy, because unless modified by 2028, the current system can only pay out 80% of benefits starting in 2035.

Even without that reduction, Social Security is not enough to live on for most people. When you consider the Federal Reserve reports that nearly ¼ of non-retired adults in 2021 had no retirement savings at all, it becomes painfully obvious just how dire the situation is for most Americans today.

Beyond government programs, the conventional wisdom has been to invest in a tax-deferred qualified retirement plan such as a traditional individual retirment account (IRA), Simple IRA, SEP IRA or 401(k). These vehicles allow for a current tax deduction along with the ability to allow investments to compound profits year over year until distributions are ultimately taken at retirement age.

401(k) and IRA plans allow you to set aside a portion of your earnings for your retirement years. However, common perceptions about these “saving” tools is not inaccurate. I’ve never been a fan of tax-deferral vehicles (Traditional IRA’s, 401k’s, Defined Contribution Plans, Cash Balance Plans). Many people incorrectly believe that they are tax “savings” plans. The fact it, the tax is only deferred to a later date. This may create secondary unanticipated consequences.

So, let's delve into the reasons behind this and explore strategies to help ensure a comfortable and enjoyable retirement rather than a poverty-stricken one.

The drawbacks of traditional retirement plans

While contributing to a 401(k) is better than not saving at all, it’s far from the best, or in my opinion, even a good option because it comes with far more drawbacks than advantages.

This means despite saving often a significant amount of money, people often end up with far less than they could have, leading to a lower quality of life in their retirement years, as well as having less to pass on to family. It is interesting to note that the current generation of Baby Boomers will be the first generation to rely on the 401(k) as a retirement plan. The days of defined benefit pension plans began to disappear in the 1980’s as Congress and Wall Street colluded to create the defined contribution plans that are in vogue today. 

The difference between the two is substantial; the former defined benefit plans were considered fully funded for vested employees but became unsustainable for the corporate world.  The newer defined contribution plan puts the responsibility and risk on the individual — perhaps as it should be, but the question remains, “is the individual capable of planning for retirement?”

Taxes make a 401(k) far less predictable than most realize

Yes, you’ll get a tax break (tax deduction for the contribution) every year you’re working and saving for retirement, but that break now comes at a future cost.

Essentially, you’re deferring the taxes on that income, which you’ll have to pay when you later take distributions from your account. Many of us feel great about saving for our retirement and think we can worry about the details later — but once we hit retirement age, many realize they made a mistake, but by then, it’s too late.

Over time, we can expect our tax rates to increase. That means you’ll often pay more in taxes on your distributions than you’ve saved by contributing to the account in the first place because even the tax-deferred compounding may not be enough to compensate for the higher taxes paid in the future.

You will also miss out on several significant tax benefits with a 401(k) compared to other asset types, including depreciation, cost segregation, and long-term capital gains tax treatment. Withdrawals from a tax-deferred account are paid at the highest rate, known as “ordinary income” taxes. In addition, you’ll also lose the stepped-up basis allowance on assets you wish to pass to heirs, inflicting a higher tax and making it harder to transfer generational wealth.

Your funds are inaccessible until age 59.5

These accounts are a commitment, which by itself is not a bad thing, but as in everything, there is a price to pay. All the money you place in your 401(k) or IRA account is held hostage (locked) until you turn 59.5 by Wall Street money managers.. You can pay a pretty hefty penalty to gain access to the funds earlier, but until then, Wall Street manages the money for you.

That capital is essentially “unavailable” to you should you find better investment opportunities along the way. You cannot use that cash to invest in better options that may present themselves.

You’re trusting your future to Wall Street

Investing in 401(k) retirement accounts entrusts your financial future to financial advisors and money managers. This arrangement doesn't teach you how to maximize wealth or generate cash flow from your assets. This is a huge disadvantage you don’t hear about because it lines the pockets of the big shots handling your money for you. You take the risk; they make the profits.

If you come across another investment opportunity you’d like to explore, and your retirement plan doesn’t offer it, there’s nothing you can do. Your limited options are designed to keep plan administration costs low to “save you money.” But those same limitations prevent you from fully controlling your assets.

And anyone who has been following the financial industry over the last few decades has seen first hand how the giant institutional investors like banks, pension funds, hedge funds, and insurance companies, are always taken care of at the expense of individual investors.

Not to worry — there is a fix to the problem created.

All is not lost if you are in the majority who has “saved” money in a tax-deferred retirement account.

Roth conversion

If you want to save money on your taxes in the long run, consider converting your traditional IRA to a Roth IRA. You’ll pay taxes on any money converted in the year you convert, but the money grows tax-free and you won’t have to pay any taxes on the money you withdraw from the account after retirement. .

There are four main retirement account types that can be converted to a Roth IRA: traditional IRAs, 401(k)s, SEP IRAs, and SIMPLE IRAs.

Plus, you can self-direct your IRA investments, giving you greater control over what happens to your assets. You can make your money work harder for you so you save more for retirement compared to using the same investments in a 401K. Your self-directed IRA can invest in almost anything, including my favorite asset — real estate.

J-Curve strategy

This is a tactic that utilizes the Roth conversion method above with an additional tax savings should market conditions cause a decrease in the value of an investment asset in the traditional tax-deferred account.

If you convert a non-cash asset from a traditional IRA to a Roth IRA and the asset experiences a temporary loss in market value, the tax on converting the asset is proportionally lower, based on the decreased asset value when you make the conversion.

Anyone who has invested in mutual funds, stocks, bonds or real estate and experienced a market loss can also use this strategy. This approach has saved investors massive amounts of money - hundreds of thousands. And, when the asset increases in a Roth IRA, the distributions are still tax-free compared to the same assets in a traditional retirement account.

It’s time to unlearn what you “know” about retirement savings

While the mainstream financial media and pundits continue to laud the benefits of tax-deferred retirement accounts, you should now be able to at least recognize that the majority of the benefits lie in the hands of those who promote these vehicles.

While a disciplined savings and investing account is by itself a good thing, those who want more control over their financial future would be advised to become a more sophisticated investor and manage their money and investments themselves vs. abdicating that control and responsibility to the whims of Wall Street money managers.

Working hard during one’s active income years to create the financial base for retirement takes decades.  Don’t gamble your future just because you were told that financial planning and investing is “too complicated.”  The sellers of various plans purposely create a multitude of products to sell with very little concern for the outcome of their clients.

It’s time to think outside the 401(k) box and take control of your financial future.
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Dr. David Phelps created Freedom Founders to help its members achieve the freedom they wanted in their lives by building the necessary financial foundation. He is a noted financial expert who is regularly cited by the media, and recently helped the FL Dept. of Education develop its new financial literacy curriculum.