Far too many employees consider their companies’ 401(k) plans to be too bad to participate. This is a mistake. The most common complaint is that the plan doesn’t match their contributions. The lack of employer matching contributions does not turn a good 401(k) plan into a plan that should be avoided. It simply means each employee will have to be more responsible for his and her own contributions. The era of employer-funded pensions is fading and employees shouldn’t rely on their companies to fund their retirement. I have plenty of clients who never had a company match their contributions and they have been able to save sizable nest eggs on their own.
While many 401(k) plans have excessive fees (which does make a 401(k) “bad”), the tax benefit is almost always worth higher fees in the short-term. (Hint: You can complain about the high mutual fund fees and request the plan add low-cost index funds to the mix. Most plan sponsors will help push the plan’s advisor to have better funds if requested. If not pushed, too many advisors will overcharge contributors.) Consider this – for an employee in the 28% tax bracket who forgoes contributing to her 401(k) plan, she only has $0.72 to invest what could have been $1.00 if she contributed to her 401(k). This is simple math. $1.00 before tax is equal to $0.72 after paying a 28% tax. On a larger scale, $10,000 before tax is equal to $7,200 after paying a 28% tax. These 28 cents matter. Obviously, it’s much worse for those in higher tax brackets.
If you skip the rest of this article, read these two bullets:
- An investor would need more than four years at an 8% annual return to catch up to investments that could’ve been made tax-free and that’s without factoring in additional taxes from capital gains in the non-retirement account.
- Not contributing to an employer’s retirement plan is equivalent to only making investments at the beginning of a bear market when the market drops 28% and it happens in the blink of an eye.
I’m a firm believer in saving additional funds in a taxable investment account after maximizing a qualified retirement plan. For those who would prefer to spend their earnings now rather than retire earlier or have a larger safety net, research has shown that if begun early in their careers, those who save 15% of their income per year, in a tax-free account will provide sufficient retirement income (coupled with social security) for most people.
401(k) Alternatives
Worse than having a bad 401(k) is not having a 401(k) at all. These unlucky employees need an alternative, just as those who are hit by the Highly Compensated Employee rule. Here are a few alternatives for your cash:
- If you and your spouse do not have access to a qualified retirement plan at work, a Traditional-IRA or a Roth-IRA (check income limitations) can be a good alternative. If you or your spouse have access to a 401(k), you may not be able to deduct your contributions, so check with an advisor or read up on the rules before making a mistake.
- If you have children (or are a generous aunt or uncle), consider investing in a college savings plan, such as a 529 Plan or an Education Savings Account (ESA).
- Pay down your home mortgage faster. The faster you pay down your mortgage, the less you will spend on interest and the more free cash flow you will have. I ask all of my clients to plan to have their mortgages paid off before they retire. Eliminating this large fixed expense before your regular income stops can make retirement savings last much longer and help insulate you from fluctuating market conditions. While the return on investment from paying off a low interest loan might not be big, the piece of mind and security from eliminating a large debt can massive.
- If you cannot find a way to save pre-tax, funding a taxable savings account is better than not saving for your future. After you’ve maxed out your pre-tax savings options, investing in a taxable investment/savings account can be a great way to reduce the stress of unforeseen expenses that arise and can open the door to retiring early if you’ve saved enough and kept your fixed expenses low enough.