One of the major benefits of a 401k is it allows you to divert taxes on today’s income to your retirement years, when ideally you will find yourself in a lower tax bracket.
Of course, that benefit is not always a given. Tax rates could increase, or your income needs could increase in retirement. Either way, you might find yourself paying more in taxes than you planned on earlier in life.
For me, the tax advantages do not outweigh the other problems/limitations of a 401k. Of course, much of this is very personal, as the company I work for chooses the plan administrator, and the administrator controls the investment options. Your options may or may not be significantly better.
Your employer may also offer a match to your contributions, which would be very hard to pass up as it essentially “free money” towards your retirement.
Having said all that, I chose to not participate in my employer’s 401k for a variety of reasons, but it largely comes down to freedom.
I prefer to invest in things that give me the most freedom – freedom of investment choice, freedom to tap my money if necessary, and freedom to have more control over taxable events now and in the future (sale of stock, withdrawals, etc.).
Roth IRA – An Alternative to the 401k
My wife and I both invest in a Roth IRA. Here, our contributions can always be withdrawn for any reason without penalty, which in effect makes this an extension of our emergency funds – not necessarily a dedicated emergency fund, but additional dollars we could withdraw if it really hits the fan.
The earnings will grow in our Roth IRA accounts and may be withdrawn tax free upon reaching retirement age (59 1/2). If we need money from the Roth before that, we can withdraw contributions without penalty.
Contributing to a Roth IRA also allows us to have more choice with our investments. Rather than being limited to a few mutual fund options with what I believe to be questionable allocations to particular segments, regions, etc, I can invest in something I feel reasonably sure will do well over the next three or four decades. I can speculate with some of my retirement money, or be ultra-conservative, whatever my appetite for risk happens to be at a particular life stage.
Outside of the Roth IRA I prefer to invest in taxable investments, again where I can control taxable events, income, withdrawals, etc. I’ve previously mentioned my strategy to build a portfolio of dividend growth stocks. I would like to eventually own real estate that produces rental income.
I also plan to tap investments before the government-scheduled retirement age of 59 1/2. I don’t know exactly when that will be, but I imagine I will stop working for full-time pay well before 60. I may work part-time, or start my own business, or change careers – who knows. But I’d like to be able to use some of my own money according to my own time table.
Potential Drawbacks to Stopping Your 401k
I am not advocating people stop contributing to their 401k without strong consideration, I’m just sharing my personal strategy. This is how I would allocate funds after getting out of debt:
1. Invest in a 401k up to an employer match. If no match, go to step 2a.
2a. Save a one-year emergency fund in all cash.
2b. Max out Roth IRA contributions.
3. Invest in taxable investments with a low turnover, including single stocks (don’t forget diversity), tax-advantaged mutual funds, hard assets (gold, silver, real estate), certain types of tax-friendly bonds or Treasuries, etc.
One of the benefits of a payroll deduction to a 401k is that the money is siphoned directly out of your paycheck and into your investment accounts. It’s like putting retirement savings on auto-pilot.
Those lacking the discipline to save on their own may benefit from the level of automation a 401k plan provides. I prefer to take a more hands-on approach with our investments, but that doesn’t mean everyone else does (or should).
I’m not one to put out a lot of disclaimers, but I would remind you that you should never do something, or not do something, with your money just because someone on a blog, or TV, or the radio, advocates it. Do your own homework. Talk with a professional. Make your own informed decision.
I’m interested to hear more from readers on this subject. Do you currently invest in a 401k?