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401(k) or IRA? What to Do If Your 401(k) Stinks

Some investors are fortunate enough to have 401(k) plans run by low-cost administrators, offering low-cost investment options. For most investors though, the situation is quite different:

  • The typical 401(k) plan charges administrative fees ranging from 0.5% to 1% per year, and
  • The investment options are often limited to actively managed mutual funds with expense ratios of 1% or more per year.

At a grand total cost of 2% or so per year, investing via a 401(k) plan is not cheap. In contrast, with an IRA, there are no admin fees at all (at most brokerage firms), and you have access to super-low-cost index funds and ETFs with expense ratios of 0.20% per year or less.

So does it make sense to forgo 401(k) contributions in favor of maxing out an IRA?

Not necessarily.

Get that 401(k) Match!

Before contributing to an IRA, be sure to contribute enough to your 401(k) to get any match that your employer offers. In nearly all circumstances, a dollar-for-dollar match (or even a 50-cents-on-the-dollar match) outweighs any other drawbacks such as high admin costs, fund expenses, or a tax-preference for a Roth.

Important note: If you’ve read that your employer offers, for example, a 4% match, that probably does not mean that they contribute 4 cents for every $1 you contribute. It usually means that they contribute $1 for every $1 you contribute, up to 4% of your compensation. This is a big difference! If you contribute 4% of your compensation, they immediately double it.

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I Got My Match. Now What?

After getting the maximum 401(k) match, the best approach is typically to:

  1. Max out your Roth IRA,
  2. Then, if you still have more to invest, go back and max out your 401(k).

By following this approach, you get your employer match, you take advantage of the lower costs available via an IRA, and you tax-diversify your investments by spreading them out among both pre-tax accounts (your 401(k)) and after-tax accounts (your Roth).

Exceptions

Naturally, in certain situations, it makes sense to do things differently.

For example, if you earn enough to make you ineligible for Roth contributions, it likely makes sense to replace that step by making (non-deductible) contributions to a traditional IRA, with the intention of converting them to a Roth at some point.

Alternatively, there are some situations in which it makes sense to max out your 401(k) completely before making any Roth contributions. For example, if you’re:

  • Getting close to retirement and you’re currently in a much higher tax bracket than you expect to be in during retirement, or
  • Not very close to retirement, but you still think you’re in a higher tax bracket than you expect to be in during retirement and your 401(k) has low admin costs and fund expenses,

…then the benefit of decreasing your taxable income now — via larger 401(k) contributions — would likely outweigh the associated costs.

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Comments

  1. Good post Mike. You are right on that in virtually all cases employees with a 401(k) match should constribute enough to get the maximum match. I also agree that what to do from there is a case-by case situation.
    The longer that I work as a financial advisor the more I realize that there are few rules of thumb that can be applied.

  2. We have a few low-cost Fidelity Spartan index funds in our company’s 401(k), to which I contribute. I have asked for more of these, but my request fell on deaf ears.

    People over 59.5, however, should investigate if their plan allows for an in-service withdrawal, an IRS-allowed strategy whereby the 401(k) balances can be moved to a qualified tax-deferred account like a traditional IRA. I did this with most of my 401(k) earlier this year, and now all my money is in investment vehicles of my choice. I still contribute my 10% to the 401(k) to get the employer match.

  3. What if your 401k stinks and the employer doesn’t match nothing (stinks more)?

    The above is the case for me. So we are maxing out on my wifes 401k and maxing out on both of our Roths? Iam not contributing anything to my 401k. Is that a wise decision?

    Is anyone aware of any other way to save money for retirement PRE-TAX?

    Thank you for your time and I do enjoy this blog

  4. Hi Jay.

    In that case, I agree it’s best to prioritize your spouse’s 401(k) — assuming, that is, that she gets a match and/or has lower costs — as well as your Roths.

    After that, though, I’d still usually be inclined to save in your own 401(k) just to take advantage of the tax benefits. If nothing else, if you ever change jobs, you’ll have the ability to roll it into an IRA.

    The alternatives — investing via a taxable brokerage account or seeking tax-deferral via a deferred annuity — aren’t usually very appealing.

    To be able to say with more certainty though, you’d have to take into consideration exactly how bad your 401k investment options and admin costs are, how long you expect to stay at your job, what tax bracket you’re in now, and what bracket you expect to be in during retirement.

  5. Mike

    You made some key points like admin costs, staying in my job etc. I might stay in this job alteast for an other 2 years or so. Already been here for 2 years. So this might be a good time to take an other look at the 401k options I have. I do remember that almost al funds had high expense ratios and Iam not sure about the admin costs.

    Thanks Mike. Good luck on your upcoming new book.

  6. Hi Jay

    Just to be clear: The shorter the period of time that you expect to stay at your job, the more sense it makes to go ahead and max out that 401k. The reason is that, even if the funds have high operating expenses, it may be worth it if you’re only going to pay them for another 2-3 years before rolling the money into an IRA.

    On the other hand, if you’re going to be paying those high expenses for many years before moving the money, the costs start to outweigh the tax benefits.

    And thank you for the good luck wishes with the new book. 🙂

  7. Dividend Monk says:

    My 401k is actually pretty acceptable, as it offers low-cost index investing in equities, bonds, and savings.

    Still, I prefer to direct much of my own investing. So I invest enough to get all of the matching possible, and a bit more, and then max out my IRA with individual stock picks. With the remainder, I invest in a taxable account for individual stock picks.

  8. Some of your readers may be interested in this recent post:

    http://rwinvesting.blogspot.com/2010/10/how-does-your-401k-stack-up.html

    It details how they can assess their 401k versus similar 401ks using http://www.brightscope.com.

    With this information they may be able to lower costs and get better choices for their 401k.

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