401(k)s are employer retirement programs that allow money to be invested pre-tax, and allow interest to accrue tax-free until withdrawal. There are federal, and sometimes company, limits on how much can be contributed in one year. Companies also may match some of the contributed dollars, but usually not all.
Which brings me to my question: Should you contribute to your 401(k) beyond the amount that gives you a maximum match from your employer?
I don't know.
It's true right now that the more you contribute to your 401(k), the more the tax-free compounding works for you and the less you pay in taxes now because your taxable income is lower.
However, after you max out your company's match (say, the first 5% dollar for dollar), then you don't get any more match. The 100% bonus on your contributions stops. If you contribute 15% yourself, you still only get the 5% match, so the bonus is only 33 1/3% of your contribution. It's still twice as big as if you had only contributed 5%, but the company doesn't sweeten the pot as much.
Also, this money is now unavailable without penalty to you until retirement, meaning that it can't be used for something else. I'm not saying that this should be used for consumption. Could you use the money more effectively somewhere else? What about paying down a mortgage? What about starting up a business and getting a second stream of income? Investing in instruments that you can't in your 401(k)? Going back to school? Getting updated training?
Also, the government sets the rules for the 401(k)s, and it can also change the rules. The rules now may not be the rules in 2030. Will they be better or worse? I don't know. 401(k)s could be great places for our funds, or they could be lousy places for our funds 25 years from now. I don't have a clue what will happen five Congresses from now.
But I will take as much matching as my employer will give me. That will soften any blow that might occur, and it provides the maximum value for the dollars that I invest in the plan.
What do you think?
i've heard that any money beyond the match should be placed into a roth IRA. you won't get a tax deduction but when you withdraw at retirement you will pay little or no taxes.
Lpkitten, yes that’s certainly a good place to put extra money. There are many worthwhile places for money.
Yes, I've also heard max your match on the 401k and then switch to a roth IRA…
But what do you do if you contribute enough to get the max 401K match from your employer and you max out your yearly Roth contribution?
I used to only put 6% into my 401(k) so that I could get the employer match, but now I think that I have to start maxing it out. The reason is that my wife and I have an AGI over $150,000, so we cannot put money into a Roth. I HATE that rule.
2 Investing suggestions:
1. If the Roth IRA is available, I would try to put the extra in a Roth IRA. With the 401(k), you get a tax deduction now, and no taxes while it’s accruing, BUT you pay taxes when you withdraw the funds. With the Roth, you pay taxes before you place the money in the roth, but no taxes for the duration, and no taxes at withdrawal. By using both, it gives you the flexibility at retirement to look at whatever the tax rates are and withdraw from each according to how much tax you CHOOSE to pay.
2. If you have a mortgage, I would consider paying down the mortgage. Although the mortgage interest will likely be lower than what you could get over the long-term in an index fund, it is a GUARANTEED return on the money. For example, the S&P 500 returned single digits this year – paying off the mortgage would likely have produced better returns (from savings of interest) than putting additional money in the investment market. Additionally, if you think of the home as an investment, for many (maybe most) people, that means that the large majority of their “worth” is tied up in the home, instead of stocks. In effect, most people are over-invested in ONE STOCK – their home. Paying down what you owe will decrease the exposure/risk.
We max out my 401(k) and both our Roth’s. There are many reasons to max out the 401(k), one being that most people are unable to save money on their own. If I didn’t start out by maxing out my 401(k) at the age of 22, I guarantee that money wouldn’t be sitting in a savings account somewhere, I would have spent it.
Thanks everyone for your thoughtful comments!
The Roth IRA is a good place for extra tax-free retirement saving — for those who can use it, of course. The early withdrawal penalty is also a useful deterrent against raiding your retirement savings.
Also, don't forget that the money you are putting into your 401k is all pre-tax money. So you're growing and compounding a larger amount of money than you would by contributing after tax dollars to your Roth. This is especially impactful if you're in higher tax brackets. It only costs me around $.70 for each dollar that I put into my 401k. This is why I max it out.
In the end, I think balance is important. I don't intend of working until I'm 65 or even close to it. In order to meet that goal I'll need a combination of retirement funds and regular savings.
As of 2006, companies may now offer Roth 401(k). The rules are the same for a regular 401(k) with a max of $15,000 this year. That's a lot more than a regular Roth IRA.
I'm praying that my company will offer it, but I've had no response from HR.
The Roth seems to be great for those who qualify. My preference would be to fund the 401k up to the match, then fund a Roth IRA. But for those who don't qualify for the Roth, would we be better off with putting money in a 401k, or in a regular taxable account?
This question plagued me for a while; my wife and I maxed out our 401k, but it can be frustrating seeing that money grow and knowing it's not accessible until retirement age. Our total taxable savings now exceeds our total 401k savings (we still max our 401k), so mentally it's not so problematic, but if I had it to do over again I would have saved at least a little outside of a tax-advantaged account just for peace of mind.
If you expect your tax rate to be the same or lower in retirement, it makes sense to max out the 401(k). Even if you expect it will be higher, you might opt for an earlier retirement age instead (hence, the higher tax bracket at, say, 67 would in fact NOT be higher at, say, 55).
I think that: 1) 401(k) to the match, 2) Roth to the max, 3) 6 month savings fund, 4) 401(k) to the max, 5) Mortgage, is the best approach. You can withdraw Roth contributions tax free (after 5 years from the first Roth contribution) so, after say 5 years, you would have $15 – $20k available (and wouldn't have to consider a 401k loan). Pay that mortgage off quickly, and you might find that early retirement is better.
Personally, I would love to semi-retire at 55, and do consulting or temp work for 1,000 hrs/yr, and pay all of my bills from work (not savings). Do that for 10 years, and let the retirement savings roll. If the markets hit a rough patch, it keeps one foot in the workworld, and makes it much easier to go back to full-time at 60 for a few years, if you have to. Sorry for the long post.
– Craig
Thanks again everyone for your comments!
Craig, I wish that my goals were as clear as yours. They sound good to me!
SRH, as I'm sure you already know, the tax-advantaged accounts have advantages and disadvantages. The tax savings and the possible matching are the advantages; the early withdrawal penalties and the regulations are the disadvantages. If you have productive use for the money before retirement (say, for funding a business venture or additional training for yourself) then putting the money in a non-tax-advantaged account may be better.
I have always wondered this, but how will you effectively have more money in the long run but using the tax-deferred savings compound for you? Wouldn't the extra money really all be going to the government at retirement when you begin withdrawling? Also, we all know how tax rates go up, so wouldn't the government really be taking a larger chunk of your savings, like it would be 30% now but 35% in 30-40 years?
Jason, thanks for your comments.
The way to check is to run numbers for both cases.
There's also the matching: If you get nearly 100% matching for the first X% of your salary, that takes a lot of the bite out of the taxes at the end — even if they go up a lot.