Most personal finance experts will tell you that, when it comes to your 401K, at the very least, you should invest up to your company’s match. For example, if your company matched the first 6% of your paycheck, you’d set your contribution to 6%. It’s free money to you and comes tax deferred.
I have no gripes with this policy and in fact contribute slightly more than my company’s match at my current job.
The problem I have is when they tell you that you should max out your 401K investment if you have the funds. While the immediate tax discount you receive is somewhat alluring, I have a lot fundamental issues with this idea. Whether or not you max out your 401K is a complex decision that should be tailored to your own personal finances, not some blanket assumptions by investing pundits. This is especially true if the following apply to you:
The Funds in Your 401K Suck
My 401K is terrible. The lowest cost fund cannot be tracked online (it’s a private ticker) and the expense ratio is more than double of a comparable index fund at Vanguard.
This makes investing in your 401K a risky proposition. Assuming you stay with your company for a long period of time, if you were to invest in high cost funds because they were the only ones available in your plan, you could really miss out on some great returns that you would’ve received had you invested in a simple index fund. This would probably negate and possibly overcome the tax savings benefit you’d get from a 401K.
The reason why so many 401K plans suck is because it is typically your HR department that selects the final plan. Not your CFO or your treasurer, but the person administering your company’s overall benefits who is typically trying to keep costs down for the company as a whole. One easy way to reduce corporate costs – give your employees a crappy 401K plan.
Your Government is Incompetent in Dealing With Financial Reform
The financial reform bill is nearly passed and while it will clearly bring additional transparency and fairness to the markets, at the end of the day, it does not do enough to prevent “too big to fail.” After all the chips have fallen, and the reform bill gets signed by our President, the banks will still have everything they need to cause a huge financial meltdown and ask taxpayers for another bailout. This can only lead us to one simple and bitter conclusion:
The Great Recession will happen again.
This isn’t a direct criticism of the 401K plan itself, but the environment that you are pretty much forced to invest in once you enroll. Do you really want to invest a significant amount in this type of financial market, the one with bailouts, recessions, and big banker bonus plans, and not be able to touch your money until you’re 60?
You Might Lose Your Job
The market is still currently shaky at best, and while it’s tough to admit after having come so far since we hit bottom last year, at the end of the day, your job probably isn’t that safe. If you do end up losing your job, first of all, don’t feel alone, it happens to the best of us. But secondly, you’re going to need cash to stay afloat and blunt the potential impact of long term unemployment. You don’t want to have to borrow from your 401K investment, which would typically entail large penalities that wipe out your tax gains from contributing in the first place.
And even if you qualify for some type of hardship exception, you will still have to pay it back to your plan. There’s no free lunch and the government WILL eventually tax you.
Your Plan Does Not Vest Automatically
A vesting schedule for your 401K is essentially a way for your company to delay the vesting or full ownership of your 401K benefits, until you’ve stayed at your company for a specified period of time. It’s used quite simply to reduce turnover and encourage employees to stay longer. The rules vary by company, but a vesting schedule has a basic effect on your 401K contribution: unless you plan to stay at your company forever, you risk losing a portion of your 401K tax benefit.
This condition actually does not apply to my current 401K plan, as my company allows automatic vesting.
You Have a Need for Liquidity
This last point probably won’t apply to all of you, but there are some of us in this world who don’t like buying things on time. For example, if I were buying a car, I’d like to have the cash in hand to pay for the entire car and not have a bill payment sitting over my head for 5 years. It’s totally weird, I know. </sarcasm>
Where I go to the extreme is that one of my goals in life is to pay for my first home in cash. (Or with a very small home loan against a large down payment) I have no desire to go into large amounts of debt. If you notice the people who quickly decide to go into debt, whether it be their student loans or a mortgage, you’ll notice that they tend to stay in debt for the rest of their lives. I don’t EVER want to go into debt, and if I plan accordingly, I can achieve this.
And while this goal may seem extreme and somewhat unattainable, the financial impact of this strategy cannot be questioned. The amount you’ll add to your net worth by NEVER going into debt – no car loans, no student loans, no mortgage – is immense and would likely surpasses any gains you could expect from a 401K.
I think my inspiration for this post really comes from the fact that many investors are misled with blanket investing advice. At the end of the day, you need to make your own investing decisions based on your personal situation.
For me most of the above points apply but I still contribute a fair amount to my plan. At the beginning of the year, I was investing at 20% and was on track to max out the $15,000 contribution limit to the 401K. I’ve since reduced it to 8% and I’m not looking back. My company matches the first 4% of my contribution.
Please note that none of the above points apply to the Roth IRA, which I am a big fan of and is much more liquid than both the Traditional IRA and the 401K.
Photo Credit: wonderwebby