You’ve probably heard more than once how important it is to save your money in a 401(k)-retirement plan. Traditionally, doing this will slowly build long-term wealth as your contributions get invested and grow thanks to the compound interest effect.
However, is a 401(k) always the best route to go? Could there be times when other retirement plans or investment strategies might pay out better?
Of course! Below are a few of those special circumstances that you’ll want to consider.
When Shouldn’t You Contribute to a 401(k)?
Here are a few of the times when putting your money into a 401(k) just won’t be to your benefit.
1. Your Employer Doesn’t Offer One
The first thing to consider is a 401(k) plan is an employer-sponsored plan. The simple fact is that if you work for a company that doesn’t offer one, then you won’t be able to use a 401(k). Instead, you’ll want to look for other alternatives (such as those mentioned below).
2. Poor Investment Choices
Not all 401(k) plans are created equal. Each plan administrator – i.e., the company that works with your employer to facilitate the 401(k) plan – uses a different financial platform. Ultimately, they have the final say-so over which funds and types of securities are available to participants.
Generally speaking, larger companies may choose to work with well-known financial houses like Fidelity and Vanguard which provide access to a wide and diverse range of mutual funds. Some even allow you to purchase stocks and ETFs (exchange-traded funds) if you feel inclined to do so.
However, there are many smaller 401(k) plans that only permit participants to invest in a limited handful of funds. Based on your investment strategy and tolerance for risk, those funds may not align to your wishes, so it wouldn’t make sense to utilize them.
3. Funds Are Expensive
Even if your 401(k) plan has diverse fund options, there is also a risk that they might be expensive. One of the biggest criticisms of 401(k) plans is that the expense ratios of the available funds are much higher than what investors could find on their own.
For instance, the average 401(k) plan fund carries an expense ratio of 1.0 percent or $1,000 for every $100,000 invested. Some people even complain that their plans have funds that charge as much as 2 percent annually.
Meanwhile, retail investors who open accounts with any of the major financial platforms will find much cheaper options. As an example, a well-known choice such as the Vanguard Wellington Fund Investor Shares (VWELX) has an expense ratio of just 0.24 percent. A few years ago, Fidelity even started offering some competitive index funds that carry a zero-expense ratio.
As you might guess, the more expensive a fund is, the less money it will put in your pocket. Therefore, if you can invest in comparable funds with lower expenses, then it might lead to a higher portfolio balance over time.
4. Administrative Fees are Expensive
In addition to the fund’s fees, 401(k) plans also charge a separate fee for the plan itself. This is called an administrative fee. Depending on the agreements between your employer and the plan administrator, it could eat up another 0.5 to 1.0 percent of your annual returns.
By contrast, most financial platforms will not charge administrative fees for IRAs. They also don’t have commissions or account fees for people who buy stocks and ETFs.
5. No Employer Matching
Perhaps one of the biggest benefits of a 401(k) plan is when participants get employer-matching contributions. This is when the company you work for contributes a set amount for every dollar you decide to save. It could be something like $0.25, $0.50, or even dollar for dollar depending on the organization.
This is a great benefit and source of motivation for people to save as much as possible. Effectively the more you save, the more employer-matching contributions you’ll receive. However, if your employer has decided not to have any matching contributions, then this incentive isn’t there.
Alternatives to Your 401(k) Plan
If it turns out your 401(k) plan isn’t the best or has some of these negative qualities, then it may be in your best interest to go with another type of retirement investment account.
By far one of the most common types of retirement plans for people to use is an IRA. IRAs can be opened at virtually any financial institution and include just about any type of product they offer. IRAs are similar to 401(k)s in that the money contributed and any earnings will be tax deferred. On the flip side, you could also choose to with a Roth IRA instead. Roth IRAs are where your contributions won’t be tax-deductible. However, after age 59-1/2, all your withdrawals will be tax-free.
Another way to save for retirement is just to invest the standard way through a taxable brokerage account. Though you won’t get any tax deductions and the earnings won’t be tax-free, you can effectively delay paying taxes on capital gains on stocks and ETFs as long as you don’t sell any of the assets. Given the pros and cons, it may help to talk with a financial professional and compare what the net benefit would be going this route as opposed to a 401(k) plan with more expensive options.
No matter which way you decide to go, what’s important (and within your control) is to save as much as possible. The best way to do this is to mind your spending habits and continuously look for good ways to divert more of your income toward your nest egg. A budget can help you to manage this task.
There are many effective ways to budget your money. However, one of the simplest is to use an app that like Buxfer that seamlessly connects to your bank and credit card accounts. This method collects every transaction and condenses it down to one convenient dashboard. The more you’re able to monitor this activity, the more opportunities you’ll uncover and use to increase your savings rate.
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