Recently, I developed several financial plans for clients who work for employers with weak 401(k) plans. These plans have few investment options, don’t offer proper diversification tools, and utilize mutual funds with poor track records. What did I advise these clients to do? It depends on the individual’s personality.
First, let’s briefly review the benefits of participating in a 401(k) plan. A 401(k) plan offers employees the ability to invest in their retirement on a tax-deferred basis. Employees can invest up to $16,500 ($22,000 if they are over the age of 50) without having to pay taxes on that income until the money is withdrawn during retirement. Additionally, many 401(k) plans offer an employee match. For instance, an employee might get a 50% match on all contributions up to 8% of their salary. In this case, if the employee contributed 8% of their salary, they would automatically receive a return of 50% on their investment. Not bad!
So should an individual invest in a 401(k) even if the investment options are sub-par? First, the individual should assess their commitment to investing and whether they are disciplined enough to stick to an investment strategy. An unspoken benefit of 401(k) plans is that contributions are made from an employee’s compensation automatically, so the investment is sure to take place. Some individuals intend to make contributions to an IRA or a Roth IRA, but never get around to writing a check. If the investor isn’t committed to saving for retirement, or lacks the discipline to continually contribute to an IRA, the 401(k) is still likely the best option.
Investors who are devoted to saving and continually place making retirement contributions ahead of spending may want to utilize a different strategy. First, if the individual’s employer matches contributions to the 401(k) plan, the investor would be wise to take full advantage of that match. However, the investor should only invest the amount necessary to obtain the full employer match, and then invest additional retirement funds in an IRA or Roth IRA. Of course, IRAs have access to a virtually unlimited number of mutual funds, of which an investor could develop a diversified portfolio consisting of high performing investments.
Thus, devoted individuals should first contribute as much as necessary into a 401(k) to obtain the full employer match. After taking advantage of the match, the investor should make maximum contributions ($5,000 or $6,000 for those over 50) to an IRA or a Roth IRA, where they have a wider range of quality investment options. If the investor wishes to save more than is allowed in the IRA, they could then return to investing in the 401(k) and take advantage of it’s tax-deferred benefit.