In many cases, the 401(k) is the quintessential retirement plan. If you have access to an employer-sponsored option, it is usually a 401(k). Plus, this form of retirement account has been around for ages, making it seem like an incredibly solid choice. But, while a 401(k) can be a great way to save for retirement, it isn’t always ideal. In some cases, you might actually be better off with an alternative. If you are wondering whether a 401(k) is the best option for your situation, here are some points to consider.
Many people who have access to a 401(k) through their employer are eligible for an employer match. Usually, that means that the company will make a contribution to the employee’s retirement account up to a certain percentage of the worker’s wages.
For example, if an organization offers a match up to 3 percent of the worker’s salary, and the employee earns $60,000 per year, the company would contribute up to $1,800. If the worker allocates 3 percent of their income to the retirement plan, they end up with their $1,800 contribution as well as another $1,800 from the company, bringing the total to $3,600.
In nearly all cases, contributing enough to a 401(k) to maximize the employer match is smart. The employer’s contribution is essentially free money, so it shouldn’t be overlooked.
However, if your employer doesn’t offer a match, then you might want to reconsider using a 401(k) at all. This is especially true if the plan has very few fund options, and none of those offered meets your needs. In those cases, it might be worth exploring Traditional IRA or Roth IRA options elsewhere, as you can often find a broad range of options, and only turning to your 401(k) after you have hit the IRA contribution limit for the year.
The Income Tax Factor
When you put money into a 401(k), it’s usually pre-tax income. This means you are lowering your tax liability for the year, so you won’t owe as much when you file your federal taxes. Instead, you’ll owe taxes on the cash when you pull the money out during retirement.
Whether a 401(k)s tax advantages help or hurt you depends on your situation. If you are in a higher tax bracket currently than you will be in retirement, then the ability to lower your tax burden now is a benefit, suggesting taxation rates stay similar. You’ll be spending less of your money on taxes overall.
However, if you are going to end up in a higher tax bracket during retirement, then using a 401(k) is actually hurting you. By delaying the taxation on that money, you are going to end up paying more.
Similarly, you usually have fewer tax deductions in retirement as well. For example, you might not have any dependent children living at home once you retire, and you might not be paying a mortgage, causing that interest deduction to disappear. As a result, by waiting to pay taxes on your retirement savings, you could end up owing more even if your income level is similar or even slightly lower in retirement.
If your tax bracket might be higher or deductions significantly lower when you retire, then you’re better paying taxes on your retirement contributions now instead of later. That means a Roth IRA, where your contributions are taxed, but your withdrawals (including on your earnings) are tax-free, might be an alternative worth exploring.
The “Set It and Forget It” Argument
One of the biggest benefits of using a 401(k) is that you can automate your retirement savings with ease. Usually, you simply tell your human resources department how much of your income you want to contribute, and they take care of the rest. Even portfolio selection is typically pretty simple, partially because your options may be very limited.
However, this isn’t necessarily a strong argument against Traditional or Roth IRAs. When you set up an IRA, you usually have the ability to set up automatic deposits into that account. While the money doesn’t come directly out of your paycheck before you receive any cash, it’s essentially the same process. You just have to track the contribution in your budget the same as you would with any other recurring expense. Once you do that, you are all set.
Income Restrictions and Contribution Limits
With a 401(k), your income level doesn’t impact your eligibility. As long as you are with that employer, your salary can get sky high, and you can still contribute. Also, the contribution limits are pretty generous. For 2019, if you are under 50 years old, you could allocate $19,000. If you are age 50 or older, the limit went up to $25,000.
With a Roth IRA, there are income restrictions. For 2019, if you are single, your adjusted gross income (AGI) has to be below $122,000. Otherwise, the amount you are allowed to contribute is reduced. Plus, if your income reached $137,000 or higher, you aren’t eligible to contribute to a Roth IRA at all.
Additionally, Roth IRA contribution limits are lower than with a 401(k). For 2019, you can only contribute $6,000 if you are under the age of 50 or $7,000 if you are 50 or older.
Traditional IRAs don’t have income limits, but there are contribution limits (they are the same as with a Roth IRA).
Selecting the Best Approach
While how you save for retirement is a personal decision, there are a few options that work best for many people. First, if you have access to an employer 401(k) match, then contribute enough to your 401(k) to maximize that benefit. Next, switch over to either a Roth IRA if you are eligible for a Traditional IRA if you are not. Then, if you max out your IRA, move back to your 401(k).
For those who don’t have an employer match, you might be better off starting with an IRA. Both Traditional and Roth versions give you more portfolio options that most 401(k) plans, so you have more control. Plus, if you might have a higher tax burden in retirement, starting with a Roth IRA makes sense if you are eligible. Once your IRA is maxed for the year, then use your 401(k) after that to keep saving.
Either of those options above can be great for retirement planning. However, you want to consider your personal financial situation before you make a decision and thoroughly evaluate your 401(k). Since 401(k) plans can vary significantly from one employer to the next, you need to examine yours carefully before you choose how to proceed. At times, the 401(k) might be enough, especially if you have a lot of investment options to chose from and you are confident that your tax liability will be significantly lower in retirement than it is now.
Do you have a 401(k)? Do you think it is helping you or hurting you? Share your thoughts in the comments below.
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