If you've read Free Money Finance for any time now, you know how much I love 401ks. They remove some income from taxes this year, grow tax-deferred, and with an employer's match, offer FREE MONEY! Is this a great deal or what?
So when I saw this question about 401k's posed to Money, I just had to post on it. Here's the question:
I'm unsure how much I should contribute to my 401k. One expert says you should contribute the max, even if it's beyond what the company matches. Another says to limit the contribution to the amount the company will max, and then direct the rest of your money to prepaying your mortgage.
The theory there is that tax rates are very low today and thus could rise in the future, which means by fully funding your 401k, you'd be avoiding low tax bill today for a higher one tomorrow. What do you think is the right course?
Here's their answer:
When it comes to saving and investing for retirement, I think the best course for most people is to keep things as simple as possible. When things get complicated, people can get caught up in the details of investment strategies and lose sight of what's really most important: accumulating a retirement nest egg that can carry you through a retirement that can easily last 30 or more years.
Given that outlook, I think it's a perfectly acceptable strategy for most people to contribute the maximum to their 401k. Yes, it's possible that higher tax rates rise in the future could put you into a higher tax bracket and thus erode the tax-benefit of a 401k.
But if that were to happen -- and, remember, we don't know what tax rates will be in the future -- it's not as if your 401k balance would become worthless. You would still benefit from the tax-free compounding of gains before you withdraw your money. It just wouldn't be as sweet a deal as it would be if tax rates remain the same or fall.
I also think there are practical reasons that simply sticking to a 401k makes sense, the biggest being that it's so convenient. Once you sign up, you don't have to do anything. The money is automatically deducted from your paycheck and goes into your 401k.
Good answer! He hit the nail right on the head.
But instead of just stopping here, Money goes on to give us another great thought on this subject:
The biggest problem most people face in building a retirement nest egg isn't finding the best investing strategy to make their money grow. It's saving the money in the first place. The fact that 401ks make this so easy is a huge plus in their favor -- and a reason why I consider fully funding a 401k a good idea even if it doesn't turn out to be (with the benefit of hindsight) the absolute best strategy.
But here is where the article turns south:
That said, I do think there is a good way to hedge against the possibility of higher tax rates in the future. Instead of fully funding your 401k, you contribute just enough to get your employer's match. You then take the money you would have contributed beyond the match and use it to open up a Roth IRA.
This year, you can contribute up to $4,000 in a Roth, plus another $500 in "catch-up" contributions if you're 50 or older. If you still have money left to save after fully funding the Roth, then funnel that money back into your 401k.
Ok, he just couldn't leave well enough alone, could he? You know why? Because his editor wanted a 1,000-word article and he only had 600 words so far.
Why else go into this "strategy" (and going on more than I'm printing here) after saying it's best to be simple? Sheeeesh!
But he comes around again (now that his word-count is up) to the original answer:
But I can't stress enough that you should only embark on this strategy if you're sure you'll carry it out. If you limit your 401k contribution and then never get around to opening that Roth IRA, you'll be sabotaging your retirement security.
Finally, he handles the mortgage question:
As for foregoing 401k contributions to prepay your mortgage, I'm not saying it's a lousy strategy, but it's not one I'd recommend -- at least not initially. By prepaying your mortgage, your "return" is essentially the after-tax cost of the mortgage interest you avoid paying. I think you should be able to earn at least that much with a diversified investment portfolio these days.
If you're closing in on retirement and you've already accumulated a nice fat nest egg, then you may want to consider shaving down your mortgage balance so you don't have it hanging over you in retirement. But during your career, I believe the focus of your retirement plan should be investing as much as you can in tax-advantaged accounts like 401ks, IRAs and Roth IRAs that will give you easy access to the cash you'll need for living expenses once you retire.
Here's what I've done through my career so far:
1. Put in all I could afford into my 401k (about 1% of my salary). Then I moved on to...
2. Put enough in my 401k to fully get the employer match. Then I moved on to...
3. Put enough in my 401k to fully get the employer match while also paying down my mortgage. Then I moved on to...
4. Fully maxed out my 401k (and I have no mortgage).
I was in the USWA union and someone stole my 401-K about $90,000. I also could not change funds when I wanted to.
Posted by: Frank Smith | March 12, 2006 at 09:45 PM