As every financial expert will tell you, saving for retirement is imperative, and your 401(k) is a great place to start. It's tax-deferred, it requires little effort on your part, and your employer may even match your contributions. But there are actually times when contributing to your 401(k) can hurt you more than it helps you. Here's a look at four times when it might be smarter to put your money somewhere else.
1. You need to keep your money liquid
Once you contribute money to a retirement fund, it's locked away until you turn 59 1/2. If you try to access it early, you must either return what you borrowed plus interest or be taxed on the amount. Depending on how much you borrow, a withdrawal may push you into the next income tax bracket, forcing you to pay more in taxes than you expected. Plus, you'll typically have to pay a 10% early withdrawal penalty.
If you think there's a chance you may need that money in the future to cover bills or a home down payment, you're better off leaving it in your savings account. It won't earn as much interest there, but you'll be able to use it as you see fit without fear of penalty.
2. You have a lot of high-interest debt
High-interest debt, like credit card balances, can quickly spiral out of control. What starts out as a $1,000 balance can balloon into nearly $2,200 by the time you pay it off if you're only making the minimum $30 payment and the interest rate is 30%. And things only become worse if you continue charging things to that card. What does this have to do with your 401(k)?
The main reason people invest in a 401(k) is so compound interest can make their money grow more quickly than it would in a savings account. But this may provide you only a 7% or 8% annual return at best, and if your credit card balances are accumulating 20% to 30% interest each year, you could end up losing money instead of gaining it. In that case, you're better off using your extra cash to pay down your high-interest debt; when that's done, you can begin saving for retirement.
3. Your employer doesn't match and you don't want to pay high fees
401(k)s are often preferable to IRAs because employers can match employee contributions, allowing you to earn free money toward your retirement. But not all employers can afford to match employee contributions. If yours doesn't, it may make more sense to put your money into an IRA instead.
IRAs hold a couple of advantages over 401(k)s. First, they offer more investment products to choose from. Second, the administrative fees are usually lower. Every retirement account charges administrative fees, and they are usually a percentage of your assets that is taken out of your account each year. Over time, these can add up and cut into your profits.
Look into your employer's 401(k) plan and find out how much you're paying in administrative fees each year. Then compare that to an IRA. If your employer's matching your contributions, it may be worth sticking around, even if you're paying a little more in fees. But if your employer doesn't match and your portfolio is costing you more than 1% of your assets per year, it's to your advantage to go where the fees are lowest.
4. You don't plan on working with the company long enough to become vested
Employer 401(k) contributions are usually not yours to keep right away. They follow a vesting schedule to ensure that employees who are only with the company for a couple of months don't walk away with company funds. The vesting schedule varies by company. Some may require you to work for the company for a certain number of years before becoming vested, while others offer a graded vesting scale where, for example, after one year you get to keep 25% of employer-contributed funds, and after two years you get 50%, and so on.
Consider your company's vesting schedule and how long you plan to stay there. If you aren't going to be with your employer long enough to become fully vested, you may not want to bother with the 401(k) because of the high administrative costs mentioned above. Plus, when you leave, you will continue paying the same fees on your 401(k) funds unless you transfer them to a new 401(k) or IRA.
A 401(k) is a great vehicle for retirement savings, but like anything, it's not right for all people all the time. If one or more of the scenarios above applies to you, you may want to think about waiting to begin saving for retirement or contributing to an IRA instead.
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