I still consistently hear a lot of folks in the personal finance space refer to 401k investment accounts as “money jail.” And to be honest, I'm not sure 100% how I feel about that.
Because I fall right on the fence.
In general, those who advocate the 401k as money jail do so because they invest instead (usually exclusively) in real estate or private equity or something like that. And I love investing in real estate and think it's a great thing. I even encourage other doctors to do the same.
But I also invest to the max in my 403b (a non-profit institution's version of a 401k) as well as other investment accounts (which often also get called money jails). And I highly encourage other doctors to do this as well. You can even see exactly how I invest my money in my 403b account here.
So, how can I rectify both of these things? Well, join me on a journey of self-exploration and let's see.
Why a 401k is really money jail
Let's start here. Because the money jail crowd does have some valid points.
- Money invested a 401k account cannot be accessed until a certain age without a stiff 10% penalty
- Investing in a 401k account limits you to only the investments available by the 401 administrator
- Money in a 401k account is tax deferred, which is maybe the least favorable of the advantaged tax treatments since taxes are likely to rise, not fall in the future
I can't argue with any of these points.
Your 401k investments are held in check by an age limit on their withdrawal and limit investing options. Like the gates and guards of a financial prison.
In the meantime, investing in real estate gives you the freedom to invest your money as your see fit and use the cash flow or realized gains right away, all with potentially huge tax advantages.
Ok. Argument over. Or is it?
Why a 401k is not money jail
Once again, it kind of comes down to the rational and irrational sides of personal finance. Above, I just listed the cold, hard facts. And if that was all that existed, this might be a more open and shut case.
But rationality does not reign supreme in personal finance. Our financial behaviors are rarely completely rational. Even mine as someone who prides myself on managing these inherent behaviors when it comes to money – like irrational spending.
So, here are the main reasons I do not believe that a 401k or other similar accounts are money jail.
- By design, 401k accounts encourage and foster a buy and hold approach with investments (which, when investing with index funds, is a proven way to reach financial freedom)
- Tax deferred money does actually give you more money to use and invest right now by reducing your immediate taxes
- It's actually a great strategy for doctors to reduce their tax burden
- Most employers will offer a 401k contribution match – that's free money you miss out on by not using it
- There are still tons of ways that you could get your money out if an emergency or something like that strikes without incurring a major penalty
And keep in mind, while this post is specifically about 401k accounts, Roth IRAs (another alleged money jail) allows for principle to be withdrawn tax and penalty free at any time. This has led some to call it a back-up emergency fund.
So, no. Investing your money in a 401k is not akin to locking it up in Shawshank.
What are we to do then?
Well, luckily there are many ways to reach financial freedom. And no one plan is perfect for everyone. It will depend on your unique perspectives, habits, risk tolerance, and other factors.
Which is to say, to some, a 401k will feel like money jail. And to other investors, it's going to feel like some magic money machine where your money can compound and create more money.
And neither is wrong. That's the beautiful thing. So, let's look at who will be most and least likely to see their 401k as money jail…
Most likely to see a 401k as money jail
Physician investors:
- With a high risk tolerance
- Later in their career with less savings and needful a higher return on their money
- With less clinical commitments and more time to focus on more time-consuming investments
- Looking for a very quick exit from medicine
- Selling courses on investing in real estate or similar other investments (Please note that I am not condemning selling courses. I sell a course teaching other doctors to improve their financial well-being. But it is a bias…)
- Have previous experience with real estate or private equity investing
- Are focused primarily on cash flow (out of need or want)
Least likely to see a 401k as money jail
Physician investors:
- With a low risk tolerance
- Who want minimal active involvement with their investments (and yes, this includes passive real estate investing which is not 100% passive)
- Planning for a long clinical career
- Who don't get an employer match
- Are earlier on in their financial education
- Are focused largely on saving and future gains
Where does this leave the rest of us?
Some of you reading this may fall nicely into one category or the other. Or, more likely, if you are like me, you won't quite fit exactly into one or the other.
So what are we to do in that case?
Well, there's no need to be quite so dogmatic as to say one or the other needs to be followed exclusively. While many thinks it needs to be one way or the other, really only a few physician investors are best served to follow just one or the other strategy.
That's why I am a huge proponent of a hybrid investing plan. And here are 10 reasons why.
A hybrid investing approach offers the best of both worlds. Plus, it adds significant diversification as well as combine tax advantages from multiple manners of investing.
Will a hybrid strategy offer as much acceleration potential as a pure real estate strategy? No.
Will a hybrid strategy offer as much security as investing solely in index funds within a 401k? No.
But it provides the best of both worlds.
What is our final verdict?
No, a 401k is not a money jail.
But it does have restrictions.
And as long as you know what a 401k can and can't do, just like any investment account or strategy, you can use it to the best of its advantage for your unique situation!
For more investing strategy insight, check out these posts:
- Sticking to Your Financial Circle of Competence as a Doctor
- How Much Is Enough Retirement Savings?
- My Written Financial Plan Update
- Guide to Creating Your Financial Goals and Priorities
And for a concise guide to creating financial freedom, check out my best-selling book, Money Matters in Medicine!
What do you think? Are 401k accounts a jail for your money? Or is that too harsh? Where do you invest your money? Let me know in the comments below!
6 Responses
A company 401k is more like “house arrest” not a money jail.
I like that analogy!
Great points.
For those lucky enough to save more than they need, the tax implications of required minimum distributions and taxes on inherited 401k assets may also be considerations.
Wow, I guess it’s time to defend 401(k)s again. Most of those telling you your 401(k) is “money jail” are just trying to sell you something. Some things shouldn’t need defending. There’s a reason the IRS limits how much you can put in a 401(k). Because it’s a gift from the government.
https://www.whitecoatinvestor.com/in-defense-of-the-401k/
Every objection people have to 401(k)s is easily overcome.
1) Age 59 1/2 rule has so many loopholes in it that you can drive a truck through them. I mean, early retirement exempts you from the rule via SEPP. It’s not even 59 1/2 for 401(k)s. It’s 55 and separation from the job.
2) Limited investments? Sure, but you really don’t want ANY of your money in low cost broadly diversified stock index funds? Buy your real estate or exotic stuff using that taxable account. If you’re not saving enough to be putting money in taxable after filling your 401(k) there’s a good chance you’re not saving enough anyway. Besides, solo 401(k)s and even your practice 401(k) if you control it can include lots of “exotic” self-directed investments. We hold some private real estate debt funds in ours. Even if you have to wait a few years to change jobs and use a self-directed IRA that’s well worth the tax breaks you’re getting. Besides, not everyone is cut out to be some sort of entrepreneur. And private equity investments are far from being required for investment success.
3) An employer match, rock solid asset protection, tax-protected growth, a possible arbitrage between tax rates at contribution and withdrawal, Roth contributions and the optionality of later conversions…what’s not to like here? I’m not seeing anything. And these days investments are as good as they’ve ever been (practically free with good index funds) and fees are lower than ever.
3)
These are great points and the exact rebuttals that make deferred investment plans like 401k’s still worthwhile and the first bucket that I fill
Always keep in mind that “The government giveth, but mostly taketh away.” During my lifetime, I have seen nations ““nationalize” ie steal, private pension funds, replaced by an IOU. At the outset of my career, i worried about the “Financial Children” having nothing for retirement when they retire at the same time as me. To maintain social stability, the Goverment will pass some law to take some extra of mine to punish me for being responsible, and give money to the Financial Children. It is always bad for the high net worth individual. The 401 k ‘s and their ilk require I sell a percentage of equities every year after a certain age so they can get their hands on income taxes. Since I saved up my own money without a deduction, I am free to leave anything I don’t use to my family and they get the “step up” value which is a lifetime of untaxed capital growth to leave them.
If you 401-something includes a matching contribution from the employer, by all means take. But don’t think this is enough to sustain you in your old age.
Most people are undisciplined about money, so the usual vehicles are best for them.