Your company 401(k) plan is a great place to save for retirement, especially if you get a 401(k) match. But there are several situations when a 401(k) account isn’t the best place to contribute your retirement funds. Here are a few situations when it is better to save outside your 401(k) plan:
Your taxes are low right now. Your first priority should be to get your employer’s 401(k) match. After that, you should consider putting money into a Roth IRA instead of a traditional 401(k), especially if your effective tax rate is low. Roth IRAs allow you to pay income tax up front at your current tax rate, which can be a windfall for young and low income people who expect to be taxed at a higher rate later in their career or in retirement. Roth IRA distributions will be tax free in retirement. You can also withdraw Roth IRA contributions after five years if you truly need cash, which means this doubles as an emergency fund.
You have bad fund choices or high 401(k) fees. The money contributed to a 401(k) is tax deferred, not tax free. This means that you will eventually have to pay taxes on your withdrawals. If your 401(k) offers nothing but expensive investment choices, you may want to find another account for your retirement savings. For example, if you are paying over 2 percent every year in investment expenses just to be invested in a fund that performs badly, that could eliminate any benefit that tax deferred growth can bring. On the other hand, you won't need to pay annual taxes on any capital gains and interest payments in your 401(k), so run the numbers before you decide where to invest your nest egg.
You can save more than the annual limit. The IRS sets an annual limit on 401(k) contributions. The limit is $17,000 in 2012, or $22,000 if you are age 50 and over. Once you reach the limit, you need to put cash in a taxable account, assuming you've also exhausted the IRA limits.
If you are able to contribute the maximum amount to your 401(k), you should find out how the 401(k) match is calculated. Some people could miss out on part of the match if they front-load their contribution at the beginning of the year instead of spreading it out throughout the year. So don't assume that you are always better off if you try to contribute to the limit as soon as possible.
You have high interest debt. Saving for retirement is important, but it's unlikely that contributions to your 401(k) will exceed the benefit of paying off a high interest rate loan such as credit card debt. Can you make your investments grow more than the credit card interest rate you are being charged? Shoot for the guaranteed 14 percent or higher return by paying off high interest debt first.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.