Investing in your company’s 401(k) is a fairly hassle-free way to build your retirement savings. You set aside a percentage of your pre-tax income and in many cases, your employer antes up matching contributions which helps your money grow even faster. No taxes are due until you start making qualified withdrawals and you may even be able to borrow against your account if you need to tap the cash.
Find out now: How does my 401(k) work?
While most financial experts agree that maxing out your 401(k) is a smart move, there are some situations where it actually makes more sense to forgo participating in your employer’s plan. Here are reasons why you might be better off leaving a 401(k) account out of your retirement strategy for the time-being.
1. You have no financial safety net.
Putting money into a 401(k) doesn’t make sense if you turn around and pull it right back out again. According to a recent TIAA-CREF survey, nearly a third of Americans have borrowed from their retirement account at some point. Approximately 35% of those who took out a retirement loan did so to cover emergency expenses. Should you end up leaving your job before the loan is repaid in full, you could end up owing income taxes on the money along with a 10% early withdrawal penalty.
If you’re constantly raiding your retirement account to cover unexpected costs, it’s an obvious sign that you might need to defer your contributions and work on building up some cash reserves instead. Having a cushion in place can help you keep the rainy days at bay and you won’t have to worry about keeping up with loan payments or getting hit with a big tax bill.
2. You’re in debt.
When you’re dealing with the debt demon, it takes a certain measure of intensity to get it paid off. If you’re being charged hundreds of dollars in interest each month, that’s a big incentive to zero out your balances once and for all. The money that’s coming out of your paycheck and going directly to your 401(k) could help you reach your debt-free goal that much faster.
If you’re not sure whether it makes sense to temporarily suspend your contributions, consider how much you’re paying in interest versus the kind of returns you’re getting on your investments. If you’re shelling out 15 or 20 percent to a credit card company but you’re only seeing a return of 5 to 8 percent on your 401(k), you’re basically going in the hole. Using the money to accelerate your debt payoff frees up more cash in your budget that you can then use to play catch up with your retirement savings. (Of course, just remember that you lose out on compounding interest when you delay retirement savings and some financial experts would advise contributing even a small amount to a retirement account is a good idea as you dig out of debt.)
3. The fees are excessive.
Investing in a 401(k) may not offer any real advantages if the amount of fees you’re paying counteracts any returns you might see. The Department of Labor instituted tougher regulations in 2012 to make fee disclosures more transparent but many participants still remain in the dark about how much they’re actually paying. According to a study from researchers at Yale, 16% of retirement plans analyzed had fees that completely negated the tax benefit for young savers.
Parking your money in an IRA instead means you won’t be able to save as much since the annual contribution limit is lower but you may be able to escape some of the hefty fees. If you’re not planning to stay with your current employer for a significant period of time, not participating in their plan (and contributing to an IRA instead) saves you the hassle of trying to roll it over once you move on.
4. You’re worried about the long-term tax implications.
Contributions to a 401(k) are made on a tax-deferred basis which means you don’t actually settle up with Uncle Sam until you start making withdrawals. If you’re expecting to shift into a lower tax bracket when you retire, that’s probably not a big deal but it could be a problem if you’re expecting your income to increase.
When you’re planning your tax strategy, you want to consider every source of retirement income to see how things balance out. If, for example, you’ll be receiving pension benefits, Social Security and distributions from an IRA, throwing a 401(k) into the mix may result in a much higher tax liability. There’s no way to predict the future tax rates but hedging your bets may work in your favor if there’s a major tax hike down the line.
Find out now: How should I save for retirement?
The Bottom Line
We’re not saying that you can afford to put off saving for retirement indefinitely or that 401(k)s don’t have a certain amount of value. What ultimately matters most is how well you’re able to fit building a nest egg into the bigger financial picture and finding the best way to do that for you.
If you’re not sure how to approach saving for retirement, consider talking to a financial advisor. A financial advisor will evaluate your full financial situation and help you figure out what will be best for you. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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