Employer-sponsored 401(k) accounts allow you to defer taxes on your retirement savings and perhaps earn extra income from your employer. But building a nest egg within a 401(k) isn't the right solution for everybody in every situation. Here are five reasons contributing to a 401(k) may not be in your best interest.
No employer match. Perhaps the biggest reason to contribute to a 401(k) is because your employer will often match a portion of your contributions. Yet, for a sizable portion of Americans, this perk just does not exist. The plans that don't come with matches may also have bad fund selections, which is another reason not to participate.
Really high fees. You may also want to forgo your employer’s plan because of the ridiculously high fees that some of the fund offerings charge. Sure, you defer taxes on gains in a 401(k). But the tax advantage will be quickly eroded by a 1.5 percent annual expense fee. There are many other lower cost ways to invest in a tax efficient manner, such as in an IRA or a tax efficient index fund.
Higher tax rates on equities. Equities held outside of retirement accounts can be taxed at the long-term capital gains rate of just 15 percent, even for people in the highest tax bracket. If you hold the same index fund inside your 401(k) you will have to pay the typically higher regular income tax rate on the money when you withdraw it.
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A big retirement tax bill. Deferring taxes using a 401(k) simply means that you are shifting that income from now to later years. You will be required to begin withdrawing and pay taxes on this money in retirement. Having to make very large withdrawals each year could push you into a higher tax bracket, especially if you also have other sources of retirement income. In some cases, deferring taxes on too much income could hurt you.
Future tax increases. Between 1944 and 1945 the top tier federal tax rate was 94 percent. If you are going to be taxed at that rate again in the future, it simply makes no sense to defer your taxes now when the most you will pay is 35 percent this year. Of course, I highly doubt that a 94 percent federal tax rate is in our future since tax increases that extreme are never going to be politically popular. But it’s worth thinking about whether you expect tax rates to increase in the future.
These 401(k) quirks may cause you to rethink your retirement saving strategy. But you shouldn’t skip saving for retirement all together. Even if you don't contribute to a 401(k), you should still put money away in traditional IRAs, Roth IRAs, or taxable accounts. While minimizing taxes and fees will help you to protect your nest egg, your ability to save will still be the major reason you can retire comfortably.
David Ning runs MoneyNing, a personal finance site aimed at helping others change their habits for a better financial future. He suggests that everyone to sign up for an online savings account to get more out of our hard earned money.