3 reasons not to save on your 401 (k)
Actor Samuel L. Jackson did not experience great success in Hollywood until he was 43 years old. It’s an unconventional path for a movie star and a reminder that the road to success isn’t the same for everyone. Just as Jackson found his way to stardom, you can find your way to financial independence – with or without contributing to a 401 (k).
Conventional retirement advice involves saving 15% of your income in your tax-efficient 401 (k), increasing those contributions each year, and investing for the long term in diversified investment funds. All of this is sound and appropriate advice for most working Americans. But like everything, there are exceptions. Here are three situations in which saving on your 401 (k) may not be in your best financial interest.
1. There is no correspondence with the employer
401 (k) have their benefits, including tax-exempt contributions and tax-deferred income. But the biggest benefit is the Employer Matching Contribution, which is an employer-funded deposit paid to your retirement account. It’s free money, and you qualify for it by making your own contributions. Typically, the employer matches your contribution up to a specified percentage of your salary. If your employer offers a match, you must contribute at least enough to maximize these free deposits.
A 401 (k) without correspondence with the employer is certainly less attractive, but you should not cancel your work plan for this reason alone. The question to ask yourself at this point is: do I have a better place to put my money? Two possible answers could be a health savings account (HSA) or a Roth IRA.
Compared to a 401 (k), the HSA has lower annual contribution limits, but better tax benefits. In 2020, you can contribute up to $ 19,500 to a 401 (k), but only $ 3,550 to an individual HSA or $ 7,100 to a family HSA. 401 (k) contributions are pre-tax, but your retirement distributions after age 55 are taxed as income. HSA contributions are pre-tax and distributions for qualifying medical expenses are always tax-exempt. You can receive HSA distributions for non-medical expenses after age 65, and these are taxed as income.
If you are single and earn less than $ 124,000 per year, you can contribute up to $ 6,000 to a Roth IRA in 2020. The income limit for married filers is $ 196,000. You don’t get any tax relief for these contributions, but you can make tax-free withdrawals after age 59 1/2. Roth IRAs also have another advantage. You can withdraw your contributions, but not earnings, at any time without tax or penalty.
2. The fees are too high
High fees are a deciding factor for any 401 (k) plan. Administration fees can reach up to 2% of your account balance each year. Additionally, the funds you select as investments will also charge a fee, which can range from less than 0.1% to more than 1%. Together, your plan fees and fund fees dampen returns and limit your income growth.
If the only investment choices in your plan have expense ratios of 1% or more, consider investing your money elsewhere. You can easily open a Roth IRA, traditional IRA, or even a taxable brokerage account and invest in index funds that will provide market-level performance with minimal fees.
3. You plan to retire before age 55
401 (k) are structured to prevent you from dipping into your funds until you have left the workforce. It’s good and bad. It is a good idea to discourage savers from spending their nest egg before retirement. But it is also restrictive for those who want to take early retirement. Under the current rules, you can access your 401 (k) savings without penalty from age 55 if you are retired. But if you save enough to be able to retire sooner, you’ll pay a penalty for dipping into those 401 (k) funds.
Take-out? If you plan to retire before age 55, 401 (k) is not the correct answer. Open a taxable brokerage account and save there. You will miss out on tax benefits, but you will not be subject to withdrawal penalties. You can reduce your annual tax bill by investing for the long term in a diversified portfolio of tax-efficient stocks and funds.
401 (k) is not for everyone
401 (k) is not a universal solution. The non-negotiable steps to financial independence are to save double-digit percentages of your income and hold a diversified portfolio, both for the long term. Whether you do it in a 401 (k) or not is entirely up to you.