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How Bad Does a 401(k) Have to Be Before It Makes Sense to Skip It?

A reader writes in, asking:

“The 401K at my new job doesn’t have a single fund with an expense ratio below 1.4%. How bad does a 401K have to be before it makes sense to skip it entirely?”

As you might expect, the answer is, “it depends.” In addition to looking at the costs of the funds (and to what extent you can minimize the costs you pay by sticking to the cheapest options and picking up other parts of your allocation elsewhere), you have to consider:

  • Whether or not there is a matching contribution,
  • What you would do with the money if you did not put it into your 401(k),
  • How long you plan to stay with the employer in question, and
  • Your current and future marginal tax rates.

Is There a Match?

If your employer offers a matching contribution, that weighs very heavily in favor of contributing to the 401(k) — though perhaps contributing no more than necessary in order to get the maximum match offered — even if the investment options are very poor. It takes many years of subpar investment performance to overwhelm a risk-free 100% return right off the bat.

What’s the Alternative?

If there is no matching contribution being offered (or you have already gotten the maximum match), then it’s time to consider what you would be doing with this money if you don’t put it into your 401(k).

  • Do you have any high-interest debt to pay down?
  • Can you contribute the money to an IRA, or have you already maxed out IRA contributions for the year?
  • Is there available room for contributions in your spouse’s retirement plan at work? And if so, are the investment options in that plan better than the options in your plan?

If any of the three options above are available to you, it’s often a good idea take advantage of them rather than investing in an especially crummy 401(k).

If none of those options are available, however, the decision typically comes down to contributing to the high-cost 401(k) as opposed to investing in low-cost funds in a taxable brokerage account. If that’s the case, there are two more factors to consider.

How Long Will You Work There?

The reason high-cost mutual funds are so undesirable is that they typically lead to a lower rate of compounding for your savings, which, over a long period of time, causes you to accumulate a much smaller sum than you would otherwise accumulate.

But the expense ratios of the funds in your 401(k) are only relevant for as long as you have the money in the plan. And once you leave your job, you can roll your 401(k) assets into an IRA, where you can choose low-cost funds. In other words, you’ll only have to pay the high costs of the funds in your 401(k) for as long as you’re with the employer in question.

As a result, if you anticipate leaving the employer within the next several years, even an absurdly high expense ratio is likely to be overwhelmed by the tax savings you get from investing in a tax-sheltered account.

Looking at Tax Rates

But what if there is no employer match, you have nothing else especially attractive to do with the money (such as pay down high-interest debt), and you expect to stay with your employer for many years? Then does it make sense to invest in a taxable brokerage account rather than contribute to a 401(k) with high-cost funds?

In this case, the question comes down to weighing:

  • The improvement in performance you expect to obtain from using less expensive funds (in a taxable account) against
  • The additional taxes you would have to pay because your money is in a taxable account rather than a tax-sheltered account.

Unfortunately, this is one of those things that’s not so much a simple math problem as it is a set of several guesses, which you can then use to do a math problem if you so choose.

But, generally speaking, the lower your current tax rate (for ordinary income), the lower the tax rate you expect to pay on qualified dividends and long-term capital gains, the higher the costs of the funds in the 401(k), and the longer you expect to be with your employer, the more likely it is that the taxable brokerage account makes sense.

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