Don't Max Out Your 401(k)

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By Robert Brokamp (TMF Bro)
July 15, 2002

When it comes to saving for retirement, many Americans first turn to their employer-sponsored plan (401(k), 403(b), 457, etc.). However, in a recent BusinessWeek article, economists Laurence J. Kotlikoff of Boston University and Jagadeesh Gokhale of the Federal Reserve Bank of Cleveland claim that many investors would have more money in retirement if they contributed to accounts other than 401(k)s. Their primary reason: Withdrawals from 401(k) accounts are taxed as ordinary income, instead of at the lower rates of long-term capital gains. Not only does this reduce the after-tax benefit of a 401(k), but it might push retirees into a higher tax bracket and thus subject more Social Security benefits to taxes.

If your employer matches your contributions to your retirement plan, you should contribute at least as much to take full advantage of that free money, according to Kotlikoff and Gokhale. After that, you're probably better off putting your money elsewhere, preferably a Roth IRA if you're eligible. Implicit in this argument is that, if your employer doesn't offer a match, you should contribute the maximum amount to a Roth IRA before even considering another option.

Very Foolish advice, indeed. But we'll take it even further by pointing out two other benefits of a Roth over an employer-sponsored plan:

  • Assets in an employer-sponsored plan (and in a traditional IRA, for that matter) must start being distributed by the time the account owner turns age 70 1/2, whether the money is needed or not. Thus, the account owner loses the benefit of tax deferral on that money, and the withdrawals may move her to a higher tax bracket. However, there is no required distribution age for assets in a Roth IRA. If the money is not needed, it can continue to bask in the glow of tax-free growth.
  • Withdrawals from work plans and traditional IRAs before the account owner is age 59 1/2 results in immediate taxation and a 10% penalty. Some plans allow participants to borrow from their plans, but many don't. On the other hand, contributions to a Roth IRA may be withdrawn anytime, penalty- and tax-free. The same can be said of earnings withdrawn for first-time home purchases as long as the money has been in the account for at least five tax years. Not that we recommend this, but if you need the money, it's there.

Of course, everyone's situation is different. Should you max out your Roth IRA? Begin your decision process by visiting our IRA Center.

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