Nearly all American workers share a common goal: being able to comfortably retire one day. Yet for many the goal of retiring is nothing more than a pipedream. According to the St. Louis Federal Reserve, personal savings rates in the U.S. in April were just 5.4%. This is certainly higher than it was during the raging bull market last decade, but both historically and compared to other developed countries around the world, American workers' ability to save can aptly be described as poor.
America's dominant retirement tool
What's even more head-scratching is that there are a bounty of retirement and saving tools available to workers and consumers. Chief among those is the employer-sponsored 401(k), which over the course of three-plus decades has come to replace pensions as the primary retirement vehicle for the American worker. Based on data from Fidelity Investments, the average 401(k) savings account reached a record high in 2014 when balances hit $91,300. Fidelity notes that, on average, employees were putting away 8.1% of their salaries into 401(k)s in 2014. This is still lower than the recommended 10% to 15% recommended by most financial advisors. In 2016, the employee contribution limit is $18,000 for workers under 50 years of age and $24,000 for those 50 and over.
The potential advantages of a 401(k) are threefold.
First, 401(k)s are tax-advantaged retirement tools. They allow you to lower your income tax liability by deducting contributions from your current-year tax return in exchange for paying federal income tax when you begin withdrawing the money upon retirement. Deferring your taxes gives your nest egg an opportunity to grow over time through compounding.
Secondly, more businesses are focused on rewarding talent and ensuring their employees are set up for retirement through the use of 401(k) match programs. A 401(k) match is essentially free money being doled out by your employer as long as you match their contribution. For most businesses that offer a 401(k) match, we're probably talking about a match of 1% to 3%. This match can, over decades, really pump up your 401(k) account balance.
Finally, a regular 401(k) contribution that can be deducted from your weekly, biweekly, or monthly paycheck is a great way of holding yourself accountable. Automatic payroll deductions to a 401(k) take no effort on your part, but they do make you an active player in your retirement.
Six reasons to pass on making a 401(k) contribution
But for all the advantages a 401(k) offers, there may be times when passing on making a contribution could be a smart move.
1. You're drowning in debt
For example, one of the few times saving for retirement can take a backseat to a more immediate issue is when dealing with debt. Now I'm not talking about carrying a few hundred dollars on a revolving credit card. Instead, we're talking about five- and six-digit debt figures, which may or may not include your mortgage as well. The interest you pay on debt can hinder your ability to save for retirement, meaning it might be in your best interest to hold off on making a 401(k) contribution and instead use that extra capital to reduce your outstanding debt. Doing so should eventually allow you to optimally save for retirement.
2. You have no emergency fund
Another situation where not contributing to your 401(k) makes sense is if you're building up an emergency fund. Emergency funds are in place to protect you from unexpected events, such as being laid off from your job or dealing with a sudden medical expense. Most financial advisors recommend you be able to cover at least six months' worth of expenses with an emergency fund. If you have less than that saved, or are like the 28% of Americans in Bankrate's June Financial Security Index survey who have nothing in emergency savings, then it might be worthwhile to skip your 401(k) contribution and put aside some cash for the unexpected.
3. Your company offers no match
This is a hotly debated point since a 401(k) does offer tax-deferral of your earnings regardless of whether your employer offers to match your contributions or not. However, if your employer isn't matching any of your contributions whatsoever, or they're offering some minute match amount, say 0.5%, it could be worthwhile to look into other investment vehicles, such as a Traditional IRA or Roth IRA, that give you more options and fewer fees (two key points that we're going to probe further in a moment), which can lead to greater long-term growth opportunities for your nest egg.
4. 401(k) fees are eating you alive
While 401(k)s can be a great tool to encourage workers to save and invest for their future, they can also be a tool that bleeds them dry with fees. Aside from fees that cover the cost of managing your money, there are a bounty of undisclosed fees that can include legal fees, transaction expenses, bookkeeping fees, trustee fees, and many more where that came from.
According to Entrepreneur.com, mutual fund fees can often total about 2%, and this is taken annually! Just as your money compounds, so do the fees taken from you by the associated mutual funds you've chosen to invest in. An example Entrepreneur.com uses is a worker with an annual return of 7% and fees of 2% contributing $5,000 annually for 40 years between the ages of 25 and 65. By retirement, this individual should have $1.143 million, but they'd instead wind up with only $669,400 due to mutual fund fees. A separate study from NerdWallet in 2013 found that the average household with two working adults will pay about $150,000 to $200,000 in 401(k) fees over a lifetime.
In this instance, a Traditional or Roth IRA could be a much cheaper option.
5. Limited 401(k) investment options
A fifth reason why you might consider passing on a 401(k) is the plan choices you're offered. Your employer will often a contract with a very specific mutual fund provider, which will offer a handful to perhaps a few dozen mutual fund options to choose from when investing. There arethousands of mutual funds available, but you'll be limited to a very small fraction of them.
Moreover, many of the investment options offered by mutual funds within a 401(k) tend to be geared toward safer investments and large-caps. Although this isn't necessarily bad, if you're a younger worker in your 20s, 30s, or even 40s, you probably want to also consider small- and medium-cap stocks, as well as international and emerging market opportunities to boost your long-term return rate. There are instances where you simply won't have these options with the mutual fund company chosen by your employer.
6. Future taxes could crush you
Finally, there are tax implications that you should consider. A 401(k) is prized for its ability to defer taxes until you reach your golden years. However, once you reach your golden years, you could wind up owing more in taxes than you ever did while you were working.
Keep in mind that although you're no longer receiving wage income during retirement, you're still likely to be receiving Social Security income, as well as other possible channels of income, on top of your 401(k). If you've saved a substantial sum of money in your 401(k), it could potentially push you into a higher tax bracket during retirement due to minimum required distributions once you reach age 70-1/2. This is another situation where putting your money in a Roth IRA, which has no upfront tax benefits, but allows your money to grow completely tax-free for life, could be the smarter move.