Retiree Portfolio When Not to Use Your 401(k) Plan

When you have received the maximum matching contributions your employer will make to your salary reduction retirement plan -- e.g., 401(k) -- it's time to evaluate the benefit of making additional contributions to that plan. If you use the same dedication and discipline in making contributions to an alternative investment, you can often beat the results you could achieve within your plan. To see if you could, you must do the necessary analytical comparisons between the plan and the alternative on a tax-equivalent basis. This column was first published on Oct. 23, 2000.

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By Dave Braze (TMF Pixy)
July 16, 2001

Most financial experts tell us we should take maximum advantage of tax-deferred savings. In general, that piece of conventional wisdom is true. When Uncle Sammy allows us to delay income taxes on investment gains, in effect he has bestowed on us a gift of leverage that allows our savings to compound at a greater rate than that available in a taxable account.

As a result, we are able to accumulate far greater amounts for retirement by using our salary reduction plans (i.e., 401(k), 403(b), 457, SEP, SIMPLE, Keogh) than we normally could amass in a taxable investment. That's why we say repeatedly in Fooldom you should use a contributory employer-provided salary reduction plan at least up to the point where you have received the maximum possible matching contribution from your employer. After all, that match is free money, so if you don't put enough in your plan to receive it, then it's just like throwing that free money out the window or refusing to accept a pay raise.

Once you have reached that contribution level, though, it's time to take a deep breath, sit back, and evaluate the entire situation. Far too often, after you have reached the point that provides you the maximum possible match from an employer, additional contributions to your plan are foolish -- small "f" intended. That's because many salary reduction plans offer a limited number of investment options. In fact, many plans don't even offer an index fund. Given that most managed stock funds fail to match the performance of a stock index fund over the long term, that omission in your plan may be detrimental to your financial well-being. Accordingly, once you have received all the free money you can get from your employer, you are well-advised to examine your options before you put more money into that plan.

If you don't use your employer's plan, will you be able to invest in better-performing assets in a deductible traditional IRA for the next $2,000 you will devote to retirement savings? That, of course, depends on your income tax filing status and your adjusted gross income (AGI). If you are a single filer in 2001, you may use a fully deductible IRA until your AGI reaches $33,000. Joint filers may do so until the joint AGI reaches $53,000. For details, see our IRA area and IRS Publication 590 (Individual Retirement Arrangements). If you can deduct IRA contributions and if you can achieve higher returns than those available within your plan, then certainly the deductible IRA will be better than your plan for the next $2,000 of your retirement plan contributions.

If you can't deduct traditional IRA contributions for an alternative investment, then a nondeductible Roth IRA will almost certainly be a better choice for your additional savings, as opposed to a nondeductible traditional IRA. However, a Roth IRA may not necessarily be better than your 401(k) plan. You must examine the issue based on your income tax rate today versus that in retirement.

If investment returns within your 401(k) plan and the Roth IRA are the same, and if your tax rate declines in retirement (when the money will be withdrawn), then you will not benefit from Roth IRA contributions. If your tax rate stays the same in retirement (and, again, assuming the same investment in either the Roth IRA or the 401(k) plan), neither choice has an income tax advantage over the other during your lifetime. But, because the Roth IRA passes tax-free to heirs at death, it has the advantage from that standpoint. And if your tax rate will increase in retirement, then the Roth has the advantage. The Roth has a clear-cut edge over your salary reduction plan only when you can enjoy a better rate of return with the alternative investment and when your income tax rate will be the same or increase in retirement.

It's possible that a taxable, long-term, buy-and-hold investment might also be better than your 401(k) plan. To see if it is, you must compare the two on a tax-equivalent basis after considering both the contributions and the net proceeds you will receive on withdrawal in retirement. I suggest one way to make such an analysis in Step 4 of our 13 Steps to Foolish Retirement Planning. In general, if the taxable account's return equals or exceeds the breakeven return calculation outlined in Step 4, then the taxable account will be a better option than the salary reduction plan.

The above analyses are all well and good. Each may indicate you would be better off in an investment outside of your salary reduction plan. Bear in mind, though, that to exceed the final amount you could amass in your plan, you must demonstrate the same level of dedication and discipline within that alternative investment as you would within your employer's plan.

That means you must make your deposits in that investment each and every payday without fail. It also means your deposit must increase at the same time and at the same rate as your pay does. And, it means you cannot, under any circumstances, make any withdrawal from that investment that you wouldn't make from the plan. Fail to adhere to that regimen, and you will neither equal nor beat the results attainable within your 401(k) plan. The plan demands all contributions and increases via automatic payroll deduction, so to keep pace with or to better that vehicle you must apply the same technique in any alternative.

See you next week. In the meantime, if you haven't done so yet, check out our Foolish self-paced Roadmap to Retirement Online Seminar. Set your retirement date, and figure out exactly how you'll save for it.

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David Braze has more than two decades' worth of financial planning experience, which is amazing considering that he claims to be 29 years old. Of course, he's been claiming that for a couple of decades, too. The Motley Fool is investors writing for investors.