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3 Reasons Not to Save in Your 401(k)

By Catherine Brock - Mar 11, 2020 at 8:52AM

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The workplace savings plan has helped millions of workers save trillions for their retirement. Even so, it may not be right for you.

The actor Samuel L. Jackson didn't get his big break in Hollywood until he was 43 years old. That's an unconventional path for a movie star and a reminder that the road to success isn't the same for everyone. Just as Jackson found his way to stardom, you can find your way to financial independence -- with or without contributing to a 401(k).

The conventional retirement advice involves saving 15% of your income to your tax-advantaged 401(k), increasing those contributions every year, and investing for the long term in diversified mainstream investment funds. All of that is solid and appropriate advice for most working Americans. But as with anything, there are exceptions. Here are three situations when saving to your 401(k) may not be in your best financial interest.

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1. There's no employer match

401(k)s have their perks, including tax-free contributions and tax-deferred earnings. But the biggest perk is the employer-match contribution, which is an employer-funded deposit made to your retirement account. This is free money, and you qualify for it by making your own contributions. Typically, the employer matches your contribution up to a specified percentage of your salary. If your employer offers matching, you should contribute at least enough to maximize those free deposits.

A 401(k) without employer-match is definitely less interesting, but you shouldn't write off your workplace plan for that reason alone. The question to ask at this point is: Do I have someplace better to put my money? Two possible answers might be a health savings account (HSA) or a Roth IRA.

Compared to a 401(k), the HSA has lower annual contribution limits, but better tax perks. In 2020, you can contribute up to $19,500 to a 401(k), but only $3,550 to an individual HSA or $7,100 to a family HSA. 401(k) contributions are pre-tax, but your retirement distributions after age 55 are taxed as income. HSA contributions are pre-tax and distributions for qualified medical expenses are always tax-free. You can take HSA distributions for nonmedical expenses after age 65, and these are taxed as income.

If you're single and you make less than $124,000 annually, you can contribute up to $6,000 to a Roth IRA in 2020. The income cap for married filers is $196,000. You get no tax break for making these contributions, but you can take tax-free withdrawals after age 59 1/2. Roth IRAs have another perk, too. You can withdraw your contributions -- but not the earnings -- at any time without taxes or penalties.

2. The fees are too high

High fees are a deal-breaker for any 401(k) plan. Administration fees can be as high as 2% of your account balance annually. Plus, the funds you select as investments will also charge fees, and these can vary from less than 0.1% up to more than 1%. Together, your plan fees and fund fees dampen returns and limit your earnings growth.

If the only investment choices in your plan have expense ratios of 1% or more, consider investing your money elsewhere. You can easily open a Roth IRA, traditional IRA, or even a taxable brokerage account and invest in index funds that'll deliver market-level performance with minimal fees.

3. You plan to retire before 55

401(k)s are structured to keep you from tapping your funds until you've left the workforce. That's good and bad. It's good to discourage savers from spending their nest eggs before retirement. But it's also restrictive for those who want to retire early. Under the current rules, you can access your 401(k) savings without penalty as early as 55 if you are retired. But if you save enough to allow for an earlier retirement, you'll pay a penalty to dig into those 401(k) funds.

The takeaway? If you plan to retire before age 55, the 401(k) isn't the right answer. Open a taxable brokerage account and save your money there. You'll miss out on tax perks, but you won't be subject to withdrawal penalties. You can minimize your annual tax bill with long-term investing in a diversified portfolio of stocks and tax-efficient funds.

The 401(k) isn't for everyone

The 401(k) is not a universal solution. The non-negotiable steps to financial independence involve saving double-digit percentages of your income and holding a diversified portfolio, both for the long term. Whether you do that in a 401(k) or not is entirely up to you.

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