Gone are the days of workers depending upon pensions when they retire. Today, instead of offering defined benefit pensions guaranteeing an employee a monthly payment for the rest of his or her life, employers are moving to more employee-managed retirement savings plans.
Today, more employers offer a 401k plan – if they have an employer-based plan at all. With a 401k, employees make a defined contribution from their income each year. With a pension plan, employees knew exactly how much income they could depend on each month during retirement. Now, it is up to the employees to determine how much they need to save in order to reach their retirement savings goals.
A 401k allows employees to make defined contributions, pre-tax (or post-tax), towards retirement. If you contribute to a traditional 401k, contributions are automatically deducted from your paychecks each pay period, pre-tax. As a result, you don’t pay taxes until money is withdrawn from the account and you cannot withdraw money before 58 ½ without penalties. Some employees offer the option to contribute post-tax in a Roth IRA, so money withdrawn in retirement will not be taxed.
With this change toward employee-directed retirement, rather than retirement guaranteed by the employer, it is up to you to make the best decisions regarding your retirement savings. This could mean it’s best to avoid a company 401k.
Take a look at these situations in which you should not pay into your employer’s 401K, and see if any of them apply to you.
No Employer Match
Many employers provide a match to their employees’ 401k contributions. Employer matches vary greatly by employer, but a common example of this is $0.50 per $1.00, up to 6% of employees’ pay.
Let’s say you earn 40,000 per year at your current job, and your employer provides a $0.50 per $1.00 match, up to 6% of your pay. If you were to contribute the full 6% of your pay annually, you would contribute a total of $2,400 to your 401K over the course of a year. Your employer would then contribute $0.50 for every dollar you contributed, for a total of $1,200 for the year.
In total, over the course of the year your 401K would contain $3,600, and you only would have contributed $2,400 of the balance.
But if your employer does not provide a match, it may be time to reconsider contributing to its 401K plan. Never walk away from an employer match, as it is basically free money, but if your employer does not provide a contribution match, it may be time to consider other options like saving for retirement in a traditional or Roth IRA.
You Have Reached The Contribution Limit
Effective January 1, 2015, the 401k contribution limits are $18,000 if you are age 49 and under. If you are 50 or older, you can contribute an additional $6,000 above and beyond the $18,000 regular contribution, for a total of $24,000. Of course, you are free to contribute less to a 401K, but saving as much as possible for retirement is always best.
Once you have reached the contribution limit on your 401k, you cannot make any more contributions pre-tax, and it is time to consider alternative investments.
One good alternative is a Traditional IRA. Contributions are made to a traditional IRA after tax, meaning that you pay taxes, and then make contributions out of your paycheck. For 2015, individuals can contribute up to $5,500 per year to a traditional IRA if they are 49 and under. You can contribute up to $6,500 per year if you are 50 or older.
Another solution for aggressive savers is a taxable account such as stock index funds or tax-free municipal bonds. When using taxable accounts such as these, you can expect to pay 15% on long-term gains and qualified dividends. Additionally, contributions to these plans are made after-tax. However, the benefits of using accounts such as these include being able to withdraw from them for things such as children’s college expenses before age 59 ½ without additional penalties and fees.
You Qualify For a Roth IRA
If you employer does not offer a 401k match – or a 401k plan at all – and you meet income thresholds, then a Roth IRA may be an excellent option for your retirement savings.
A Roth IRA allows individuals whose modified adjusted gross income, which you can calculate at the IRS website, is less than $135,000, or married couples whose income does not exceed $195,000 to contribute to their retirement.
A Roth IRA is different from other accounts, though, because of the way taxes are handled. Contributions are made after tax. However, once the initial contribution is made, you enjoy tax-free growth as long as you follow the rules:
- 49 and under can contribute a maximum of $5,500
- 50 and over can contribute up to $6,500
- You can withdraw your contributions (not growth) at any time without penalty
How much can a Roth IRA save in taxes? If you contribute $5,500 per year to a Roth IRA for 40 years (and increase your contributions to $6,500 per year once your age allows), and your marginal rate is 15%, this is what your account’s growth could look like over the course of 40 years:
In this scenario, you would have only paid in $230,000 during the entire 40 years you worked. You would have paid $34,500 in taxes from your paychecks.
However, your relatively small investment could grow to $1,189,636 – and you will not have to pay taxes on any of that balance when you withdraw it. If your marginal tax rate stayed at 15% when withdrawing money from your Roth IRA, you could save more than $143,000 in taxes alone.
See how much money you can save with a Roth IRA, and how much money it can save you in taxes here, with Bankrate’s Roth IRA calculator.
If your employer offers a 401k without a match, a good way to gauge whether it is a good investment vehicle for your retirement savings is to take a look at the fees. Many times both employees and employers are unaware of just how much fees are costing them. After all, 3% seems like such a small number, doesn’t it?
3% may feel like a very small amount to pay in fees, but this example will show you just how much a small percentage can affect your retirement savings.
In this example, the investor is a 29 year old, contributing $18,000 per year to her company’s 401k, and her retirement age will be 65. The current balance of their 401K is $100,000, and fees are 3%.
Just by switching to a plan that cuts fees in half, 1.5%, she could save $801,819.03. Instead of having $1.8 million upon retirement, she could have more than $2.6 million – making for a much better retirement.
Even if your 401k has high fees, be sure to consider the employer match. Many times the match will more than cover the fees, making the 401k a good investment vehicle in spite of the high fees.
If You Need Flexibility
401k’s, while they offer tax advantages, and often free money through the form of an employer match, do not offer any sort of flexibility. Contributions are automatically deducted pre-tax from an employee’s paycheck in pre-set amounts, and cannot be withdrawn without serious penalties until age 59 ½.
For many families, saving and investing money is not just about retirement. It is about college, medical expenses, large purchase, and even vacations. Always contribute to your 401k up to the maximum amount that your employer will match, but if no match is available and you need flexibility for other savings priorities, check out some of these options:
A 529 Plan: An education savings plan operated through your state or an educational institution to help families set aside income for education costs. Although contributions are not deductible on your federal income tax return, the investment grows tax-deferred, and distributions used to pay the beneficiary’s college costs come out tax-free. Some states offer tax breaks for 529 contributions, you can find yours here. In addition, there are very few income and contribution limitations, making the 529 plan a great, flexible way to save for college.
A Health Savings Account: An HSA offers individuals and families the opportunity to save money exclusively for medical expenses, and contributions are 100% tax deductible from gross income. For 2015, individuals can contribute up to $3,350, and families are allowed to contribute up to $6,650. HSA accounts holders age 55 and older can contribute an extra $1,000. If using savings for medical expenses if a priority, talk to your employer about an HSA. Not all insurance plans are eligible.
Taxable Investment Accounts: When saving for large purchases or vacations, more flexible accounts are better. As explained above, index funds, mutual funds, or even traditional savings accounts leave the account holder with more of a tax burden, but far greater flexibility for withdrawals. These accounts do not need to be opened through your employer, but can be opened and managed on your own, or with the help of a financial planner.
If your employer offers a contribution match, they are essentially offering you free money, so go ahead a take advantage of the 401k, regardless of high fees or a low income. However, if your employer offers no match, high fees, or you have reached the yearly contribution limit, then it is a good idea to avoid that 401k plan and look into other retirement savings options.
At the end of the day, saving for retirement or other goals is all about you. How much flexibility you need, how much you need to save, and your tax situation. Be sure to weigh all of your options to guarantee that you are making the best decision for you and your family.
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