When Uncle Sam gives you something for nothing, it usually pays to take it. But when tax-favored accounts come with big strings attached, it's a completely different story -- and you might well be better off saying sayonara and going your own way.
401(k) horror stories
The tax break that offers the biggest potential savings for most people is their 401(k) plan. With the opportunity to save as much as $16,500 in 2009 -- $22,000 for those 50 or over -- the 401(k) dwarfs alternatives like the IRA in the amount you can shelter from tax and set aside for retirement.
The problem with the 401(k), though, is that it requires employers to cooperate with their employees. Unfortunately, when it comes to providing a high-quality plan for their workers, many employers don't hold up their end of the bargain. To keep from having to spend a lot on administrative costs, some employers choose plan providers that offer inexpensive packages. The trade-off, though, is that those providers may then restrict workers to costly investment options that help the providers recoup the profits they give up by offering the employer a break.
Getting an education the hard way
Problems with 401(k) plans have been around for years, but more recently, another tax-favored account has raised some of the same problems. The 529 plans help parents save for their children's education by offering tax-free growth on money that they eventually use for educational purposes. With each state offering at least one plan, you can choose from dozens of different 529 plans from across the country. Often, though, going with a plan from your own state will give you additional benefits, such as a break on your state income tax.
Again, though, there's a catch. Once you choose a 529 plan, you're typically locked into a fixed menu of investments. And if those investments are bad, you may find yourself locked into a situation that will hurt your finances.
What all this means is that you end up paying for what was intended to be a free tax benefit. The question, therefore, is whether the benefit is worth the cost.
When you don't need the break
Sometimes, the answer is no. With a 401(k), for instance, if you only plan to save $5,000 or less toward retirement and your employer doesn't offer a match or profit sharing, then investing in an IRA gives you full flexibility and can leave you better off. Similarly, 529 alternatives like Coverdell ESAs and even custodial accounts may offer similar tax advantages without the investment restrictions.
But if you're getting a match or you want to take full advantage of all your tax-favored options, then you won't want to give up on 401(k) and 529 plans. Instead, there's one tip that can make or break your finances.
Look for the best investment
Even in a plan where most of your options stink, you can usually find at least one choice that isn't terrible. If your plan offers one good fund, then you might want to concentrate on that -- even if it doesn't give you the diversification you need.
For instance, say your plan offers an S&P 500 index fund along with high-cost actively managed funds. Putting all your money in the index fund may seem like a bad move because it leaves you concentrated in megacap stocks like Microsoft (NASDAQ:MSFT) and Wells Fargo (NYSE:WFC) without giving you exposure to other asset classes.
But you can use other accounts to round out your portfolio. For instance, if your 401(k) is stuck in a large-cap U.S. index fund, then you can use a regular discount brokerage account to buy individual small-cap stocks like Volcom (NASDAQ:VLCM) and Under Armour (NYSE:UA) or an international exchange-traded fund such as Vanguard Emerging Markets (VWO), which counts companies such as America Movil (NYSE:AMX), Teva Pharmaceutical (NASDAQ:TEVA), and Sasol (NYSE:SSL) among its holdings.
Similarly, if your plan has good offerings in the small-cap or international realm, then you can always buy an index fund or large-cap stocks on the side to add diversification.
You can make it work
It's annoying that so many 401(k) and 529 plans don't give you exactly the investment options you want. But if you try hard enough, you can create a well-rounded portfolio that takes your plan's investment limitations into account. By minimizing the cost of a bad plan, you can often reap the tax breaks you deserve without paying more than they're worth.
Higher taxes might be upon us soon. Learn about three ways you can beat them.
