I always assumed that we should all contribute as much as we can to our 401(k) accounts. After all, an employer sponsored retirement account allows our savings to grow tax-free, which is a major benefit, especially for those of us in higher tax brackets.
Maxing out your 401(k) means contributing the maximum dollar amount permitted for the current year. The annual contribution limit for 401(k) accounts is $16,500 in 2010 and in 2011. If your annual salary is, say, $100,000 per year, that’s 16.5% of your pre-tax income, which is a good amount to save annually according to experts.
But even if you manage to save that much, should you put it all into your 401(k)? Some say you shouldn’t.
401(k) Plans Have a Couple of Major Flaws
1. 401(k) Withdrawals Are Taxed as Ordinary Income. While 401(k) accounts allow your pre-tax dollars to grow tax-free, withdrawals from these accounts are taxed as ordinary income, instead of at the lower rates of long-term capital gains. This reduces the after-tax benefit of a 401(k), and could also push you, as a retiree, into a higher tax bracket, subjecting more Social Security benefits to taxes.
2. Many 401(k) Plans Offer Investors Limited Options. While some 401(k) plans are excellent, many others offer investors painfully limited options. If these options are not just limited, but also include problematic mutual funds (load funds, expensive funds, under-performers), then you might be better off steering clear of your employer sponsored retirement plan (except for up to the employer match), and investing in a Roth IRA or in a regular taxable account.
But 401(k) Accounts Also Have Some Important Benefits
1. Employer Match. If your employer matches your contributions to your retirement plan, you should definitely contribute up to that amount, to take full advantage of the essentially free money your employer is offering you.
2. Pre-tax Savings. Unlike other retirement vehicles, 401(k) accounts allow you to invest pre-tax dollars, which saves you a lot of money, especially in the higher tax brackets.
3. Automatic Deductions. This is a big one. Since you make your elections once a year, and then the money flows directly from your paycheck to your 401(k) account, you don’t face the temptation of spending the money instead of saving it. This is a great way to ensure you actually save.
4. Cheap Index Funds. While 401(k) plans tend to offer limited investing choices, many of these plans do offer a variety of cheap, no-load index funds. For the vast majority of investors, these funds are more than adequate.
The Bottom Line
While 401(k) plans are not perfect investment vehicles, they provide too many benefits to pass up. If you’re eligible for a Roth IRA, your best course of action is likely to take advantage of any employer match to your 401(k), then max out your Roth IRA, then go back to your 401(k) and max it out. If you still have money left to invest after all that (lucky you!), you should invest the rest in a regular, taxable account.
If you’re not eligible for a Roth IRA account, my personal belief (and what my husband and I do) is you should max out your 401(k) account, and then put the rest in a regular, taxable account. Pre-tax investing, coupled with an employer match and a likely lower tax bracket at retirement, all combine to make 401(k) plans a great investment vehicle, despite their drawbacks.
Are you maxing out your 401(k) account?
- E*TRADE IRA - Official Site