Old ways in a new world

What a week! Between election season heating up, the carry trade unwind, the market bounce back, and another hurricane for the metro New York area, it was a wild one to be sure. It was a whipsaw week for everything, including any money invested in the market. From the fever pitched selling Monday to the biggest one day gains we’ve seen in more than a year, the market was all over the place.

And if you peeked at your 401k this week, you may have gotten some motion sickness.

But why are so many of us stuffing our 401ks and IRAs to the hilt? It’s in our collective zeitgeist to maximize our deferrals and put money away for retirement so as to keep the tax man at bay. Though it would seem to me that this maxim came from the advice many of us got from older folks when we started working: “Max out your 401k and open an IRA.”

Does this old school advice still work in the world we live in today? Are we deferring the payment of tax to a time when we actually think that tax rates will actually be higher?

How did we get here?

The birth of the 401k.

In the long long ago, in the before time, we had pensions.

The 1970s saw the confluence of events that led to probably one of the most challenging economic environments in which to run a business. Interest rates were very high - 30 year mortgages started at 7.3% in 1971 and ended at 12.9% (!!) by 1979. Add to that, rampant inflation, with the inflation rate going over 12% in 1974. When money is losing value AND is expensive to borrow, it makes investing in business growth very hard; which causes a slow down in earnings, which leads to layoffs….you get the point. Add to this the fact that the top marginal tax bracket was 70% and well…

Something had to give.

And so businesses got ‘creative.’ They used cash or deferred arrangements (CODAs) that allowed employees to defer income (and thereby the tax they (and the company) pay on that income) for some period of time. But 1974’s Employee Retirement Income Security Act (ERISA) put a stop these kinds of plans because they allowed employers and executives to defer vasts sums of their income and avoid paying high rates of tax, whereas their employees were not at all able to avoid paying tax.

And so business owners went back to the drawing board. It’s pretty obvious that in an environment where rates are high AND inflation is rampant, deferring tax payments is a smart move. But now the question became, how do we do that?

Then came Ted Benna and his deep dive in the IRC. The revenue act of 1978 established the 401k but it wasn’t until 1980 that Benna found section 401, subsection k, and decided to interpret the language as actually allowing a way for the old CODA plans to fit within this law. What’s funny is that the IRS agreed with him. So he launched the first 401k plan.

And it worked like gangbusters. Today, employers can put away up to $66,000 a year for their retirement (in some cases that number can go up to $73,500) while their employees can only defer up to $23,000. To be clear, there are some limitations on how big the difference between what employees and management are putting into their respective accounts. But it’s easy, as a business owner, to defer more of your compensation than your employees. Sounds like Benna found a way to make things great for employers, less so for employees; and even he’s admitted that he created a monster.

For years now, there have been articles deriding and criticizing the modern 401k and the corresponding near simultaneous death of the pension plan. Americans live complex, modern, lives. From crazy high fees to the fact that not everyone can afford to just have money - that they earned - sitting in a vehicle that penalizes them for using it for emergencies (the way the IRS defines an emergency and what a normal person defines as an emergency are wildly different). These plans simply don’t do well with our modern lives. As a result, really, this kind of plan really just ends up being a loan to the federal government.

Wait, my 401k is a loan…to the federal government??

Yes a 401k is technically a tax-deferred retirement savings vehicle, but it can also be viewed as a kind of loan to the federal government.

When you contribute to a traditional 401(k), you do so with pre-tax dollars, which means you're deferring your tax obligation until you withdraw the funds in retirement. During the years that your money grows in the account, the federal government essentially holds an interest-free loan on the taxes you owe.

These plans only work in your favor if the assumption that you’ll be in a lower tax bracket in retirement comes true. But traditional 401k withdrawals are taxed as ordinary income, which could be higher if your retirement income is substantial - which is probably not going to happen if we also assume tax rates will be higher in the future.

Moreover, this tax deferral means that the federal government is effectively allowing you to delay paying your taxes, but not avoid them. The taxman cometh, you’re just telling hime to come back when you are no longer earning and are more reliant on your savings - what a great time to pay tax right?

The government benefits from this delay, as it allows the federal budget to account for the expected future tax income, which has been deferred. And if you decide to take a loan against your 401(k) while still working, you're borrowing your own money, but you must repay it with interest. Now, the interest you pay goes back into your 401(k), but it’s after-tax money, meaning you'll eventually pay taxes on it again when you withdraw it in retirement. Double taxation!

Stop the Madness.

All of this might lead you to conclude that we shouldn’t have these plans at all. But that’s not right either because we could use these plans - now understanding how they work - as intended. It probably, for most people though everyone is different, makes most sense to not max out contributions to these tax deferred plans and rather use regular old brokerage accounts for long-term investing. But one thing we can be sure of: this is not he 70’s. Inflation is not as bad and interest rates are nowhere near as high, plus tax brackets are far lower. So might a regular brokerage account be the answer?

These taxable brokerage accounts come with no restrictions and if you invest for the long term, at least for now, the capital gains taxes will probably be less than your income tax bracket when you retire.

The broader point here is that there isn’t just one way to save for retirement: there are myriad. And we shouldn’t latch on to just one vehilcle because its what we were ‘told to do’ when we got our first job out of school. With a bit of planning and a better understanding of how these plans work, we can all do better in saving for the future and planning for the next generation.

Speaking of next, let’s see what’s going to happen next week as we get ready for what will probably be another wild ride in global markets.

The week ahead

Inflation in focus. This week we will get a bunch of economic data on inflation and employment. On Tuesday we get PPI, Wednesday CPI, and initial jobless claims data - which was promising last week - on Thursday. In addition, Atlanta Fed President Raphael Bostic, St. Louis Fed President Alberto Musalem, Philadelphia Fed President Patrick Harker, and Chicago Fed President Austan Goolsbee are all scheduled to deliver remarks this week. What these folks say matters.

As our good friend Neil Dutta from Renmac points out in the tweets below, remarks from Fed board members have not been helpful. They really should take action at this point. Uncertainty or bad news in this data might throw markets into another temper tantrum, so we’ll be on the look out.

Retailers report. On Thursday, Walmart will share its quarterly results, following an impressive 6% revenue increase in the first quarter that took many analysts by surprise. The retail giant's strong performance led it to raise its full-year forecast.

In contrast, Home Depot is anticipated to report slight declines in both sales and profits compared to last year, reflecting how consumers, feeling the pinch of inflation, are cutting back on large home improvement expenditures.

This week will also offer insights into global retail dynamics, with earnings reports from Chinese e-commerce leaders Alibaba and JD.com. We’ll get a sense of consumer spending over the last quarter and if things are starting to slow down it may prompt some to see storm clouds on the horizon. It would seem that the uncertainty in the market is the only thing we can be certain to remain! The chart below are ETFs that track the retail industry. Over the last 12 months, the industry as a whole has seen improvement, though of late that growth has stalled - as we can see below. Let’s see if retailers report strong earnings this week, or will they tell us that the consumer is finally slowing down?

In other earnings news. On the tech front, Cisco's earnings on Tuesday might provide a glimpse into corporate spending on infrastructure, while financial heavyweights SunLife Financial and UBS are also set to report their performance. The ETFs in the chart below all track the financial services industry. One thing to point out is that this sector has been investing heavily in AI and infrastructure to make overdue upgrades to their back and middle office tech stack. But how long can this spending go on before a CFO gets wise and starts to ask questions about the ROI on all this investment in infrastructure. As we can see, the last 12 months have been really good for the industry, coming off the regional banking crisis in March of 2023; though things have faltered of late. Let’s see if investors remain bullish on the prospects of this firm creating new fintech products for the benefit of our money.