The following is the second and last part of my interview with Charles Farrell, the author of “Your Money Ratios“. Charles Farrell discuss the much maligned 401k, whether Social Security will survive, and crowd favorite, how raising personal income tax levels further will ruin America!
Question: Why do you think there are so many detractors of the 401k plan? Furthermore, do you think it is fair that the pre-tax limit contribution is only $16,500 for some 22 as well as someone who is 45? Presumably, the average 45 year old is making much more than the average 22 year old, so how come the government doesn’t propose an increased pre-tax contribution scale the older one gets?
Charles Farrell: Many people don’t like 401(k) plans because they believe the burden of funding retirements should fall on employers and not employees; thus they would like to see us go back to defined benefit plans that are funded by employers. Well, that is just not going to happen. Employers have no appetite for guaranteeing to pay their workers for 30 or 40 years after they stop working for them.
And DB plans are not flexible enough to accommodate a globally competitive marketplace, plus they discriminate against individuals who change jobs or careers. Moreover, many DB plans (particularly government plans) are significantly underfunded and many who thought they had guaranteed retirements may be unpleasantly surprised at some point. So I think the “romance” with DB plans is misguided, but many people would like to see those types of plans again. I just don’t think it’s going to happen.
Then there is another set of individuals who don’t like 401(k) plans because of the limited investment choices and sometimes high expense structure of the plans. I agree with people on this front, and there are problems with some 401(k) providers, particularly those smaller plans that can’t drive better deals on their investment platforms.
But, most plans do offer competitive options and are low cost. It’s important for readers not to lose sight of the primary reason to use a 401(k) plan, which is the huge tax benefit provided to those who contribute; and if you get a match, that is just makes it more attractive. The tax deduction, the match and the tax deferral on growth are incredibly valuable tools to help build your capital. So even with some restrictions, the plans are basically the best place to build your retirement assets.
Now, the 401(k) plan itself is not the problem. 401(k) is just a reference to the tax code section that allows for pre-tax deferrals, which is a great idea and a great tax benefit. It’s the regulations and the heavy costs of ERISA that create the challenges. At some point, we may see the ERISA issues relaxed and allow for more open plans. Some big plans already are very flexible and allow employees to open their own brokerage accounts within the 401(k), but unfortunately many aren’t. As technology improves, I expect we will see more flexibility on the investment side.
I wrote an article on the prospects of eliminating or reducing the ERISA burden for Investment News last October that your readers might appreciate.
If you happen to work for a large employer, ask about a self directed brokerage option; you may have one and not even know it; or you might be able to get your other co-workers to help push for that option.
Plus, as mentioned in the book, a lot of this could be addressed by increasing the IRA limits to equal the 401(k) limits and then let employees choose how they want to save. If you like your employer plan, then use it. If not, use your own IRA with the same deduction limits.
With respect to the tax deduction, there is one limit for those under age 50, which is $16,500, and another limit for those 50 and over, which is $22,000. I personally don’t think it’s fair to have a disparity in contribution limits based on age. Everyone should get the same tax benefit opportunity, which at this time means everyone should be able to do $22,000 if they desire.
Question: Social Security’s existence is something you vigorously defend in your book. You highlight that even if nothing is done, people retiring 30-40 years from now will still receive at least 70% of their benefits. You also discuss how you are afraid that the government will over-shift the burden of social security onto those who need it the least. Why do you think the government doesn’t do a better job in aligning the costs of the program with the users?
Charles Farrell: Social Security is one of the most successful programs because it is pretty simple. We take in money as a contribution from wages and we pay out money to retirees. It is a good hedge because the assets are not invested in the markets and it’s not a bad idea to have a portion of your income guaranteed by a government pension that you paid for. Having a basic social security benefit actually allows you to take a little more risk with some of your other money.
The problem comes when you pay out more than what people contributed, which is what is happening. The reason this happens is because of a flaw in the structure of social security. It was structured as a social welfare program, not a personal property or ownership plan. Thus, Congress can change the rules whenever they want. And it is easy to grant benefits to get votes especially if you don’t require people to contribute more to fund those benefits. I mean who wouldn’t want a bigger retirement benefit without having to pay for it?
That is what needs to change. We each need a property right in our contributions, meaning it’s our money and in general our payment is based on what we put into the plan. This is critically important to ensuring its long term viability. People get frustrated when they pay in and then don’t receive a fair deal on the payout.
Readers should fight for a property right because they are contributing a huge amount of their pay into Social Security. It is about 12.4% of everything you make up to about $107,000 (you pay half and your employer pays half; or if you’re self employed you pay the full 12.4%).
Then readers must save another 12% to 15% in their own plans, which takes us to a savings rate above 25% of pay which is more than sufficient to ensure a secure retirement. But if that 12.4% that goes into Social Security is primarily granted to someone else, then you’ve got a big problem.
The funding issues can be easily fixed at this time if voters insist on electing political leaders who promote a property right to Social Security. Politicians won’t do the right thing until they are convinced that voters want it, so let them know that’s what you want.
Question: Taxes are set to go up for “the rich” who make $200,000 or more in 2011. How high do you think the marginal federal tax rate can go before Capitalism stops working? We’re strong proponents of a flat tax system on individuals above the poverty line given as a percentage of income as well as the absolute dollar amount of taxes paid is completely equal. What are your thoughts on the flat tax, and why people argue against its fairness?
Charles Farrell: I am also for a flat tax system for most taxpayers. To me, it makes the most sense. Far too much of our productive brain power and resources are going toward tax management and it’s quite honestly a waste of energy. The only reason we have to do it is because the tax code has become so complicated.
I used to be a tax attorney, so I know this area pretty well. But the reason it is complicated is because so many taxpayers lobby for exemptions and want special treatment. They don’t want to compete on a level playing field. And since tax benefits are one of the main ways legislators can reward voters, we have a 10,000 page tax code that is basically incomprehensible.
As far as rates getting too high, we have been through multiple high and low tax cycles. So if rates rise too high, they will reduce economic growth and in the end hurt the average American, at which point people will eventually vote in leaders who want to reduce taxes. The key is to try to reduce your tax rate as much as possible during the high tax cycles by using every tax planning tool that applies to your situation.
As far as the actual tax rate, if you raise individual rates (combined federal and state) up into the 40% range, then I think it will have a detrimental effect on the economy. We are there in many states in the U.S., and I think it will hurt those states.
Readers, would love to hear your thoughts on whether you think Social Security will really be around in 30 years.
Do you think maxing out your 401K alone is enough to retire comfortably on, especially if you believe there’s no SS in your future? Is $16,500/yr max + any matching really enough to retire on?
Finally, if a smart fella like Charles Farrell believes in the flat tax, why don’t you?
Sam @ ONIG Financial Blog – “Slicing Through Money’s Mysteries”
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