When Maxing Out on Your 401(k) Contributions May Not Make Sense

The message couldn’t be any clearer. “Get the Max from Your 401(k),” shouts the March cover of Money magazine. “Max Out Your 401(k),” screams Kiplinger’s Personal Finance magazine.

It’s as much a mantra for the ‘90s as “Buy American” was for the ‘70s.

By maxing out your 401(k)--in other words, by directing as much of your salary into your company-sponsored 401(k) retirement plan as your employer and the IRS allow--you win three ways.

For starters, contributions to a 401(k) are made with pretax dollars, a benefit many of you probably noticed while doing your taxes last week.

In addition, many employers will match at least part of an employee’s contributions. A recent Buck Consultants survey of 401(k) plan sponsors found that nearly 90% of plans nationwide now offer some form of a match, perhaps dollar for dollar or 50 cents on the dollar, up to a certain percentage of your contributions. And once it’s in a 401(k), money is allowed to grow tax-deferred, with no taxes paid until it’s pulled out, generally in retirement.

That’s why Lake Oswego, Ore.-based financial planner Glen Clemans argues that “the 401(k) is the first and foremost place to go with your retirement savings.”

In general, adds Phillip E. Cook, a certified financial planner with Financial Network Investment Corp. in Torrance, “I’d say you should put as much as you can into your 401(k).”

But are there exceptions to this rule? At the risk of sounding politically incorrect, yes.

Of course, before we get into them, we should stress that for the vast, vast, vast majority of you, maxing out will still be the hands-down best way to go.

If your company matches your contributions, say, 50 cents on the dollar, you’re automatically earning 50% on your contributions--and that’s in addition to whatever returns your 401(k) investment choices will give you.

And remember, money directed into these tax-deferred plans is tax-deductible.

“Think of it this way,” says Dee Lee, co-author of “The Complete Idiot’s Guide to 401(k) Plans.” “If you’re in the 28% tax bracket and you’ve . . . made a $1,000 contribution to your plan, it only cost you $720.”

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So no matter what your 401(k) investment options are, you’ve already done better than most investors can do in an outside, taxable account.

However, “there’re going to be some instances when it might not be the best idea to max out,” says Mike McCarthy, a consultant with employee benefits consulting firm Hewitt Associates. In those cases, using some of the money you’d otherwise put into your 401(k) to contribute to a Roth IRA instead may be a better deal, especially if you don’t have enough money to do both.

McCarthy cites a couple of for-instances:

What if you work for a company with a downright dreary plan? Maybe it offers terrible investment options. Maybe it offers no match.

If your plan has drawbacks such as these, you have to judge the value of your 401(k) on the strength of only two benefits: tax-deductibility and the tax-deferred compounding of contributions.

Here’s where an IRA enters the retirement savings equation. These accounts also allow you to achieve tax-advantaged compounding. However, most people won’t be able to make any tax-deductible IRA contributions while they’re participating in an employee retirement plan. The logical IRA consideration, then, will be a Roth, because money withdrawn from a Roth comes out tax-free, whereas money withdrawn from a traditional IRA will be taxed as normal income. You can contribute to a Roth--even if you’re in a 401(k) plan--as long as your income is less than $100,000 if you’re single or $160,000 if you’re married and file jointly.

Some argue that the ability to withdraw money in retirement tax-free will eventually compensate for the fact that contributions to these plans aren’t tax-deductible.

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So who should even consider contributing to a Roth before maxing out on a 401(k)?

Those who find themselves in all of the following situations:

* Your plan offers only a small match, or no match at all. “No matter what, you should take full advantage of the company match,” says Bill McNabb, head of Vanguard Group’s institutional business. “After that, you have to weigh whether a Roth or the 401(k) is best for your situation.”

* Your plan offers terrible investment options. For instance, let’s say you can’t find a single mutual fund in your 401(k) that’s solid and suitable for you. Or the investment options all levy steep investment management fees. Over time, funds with high expense ratios (especially coupled with poor performance) will eat into your 401(k)’s advantage.

Now, having said that, financial planners note that all too often, plan participants think they have an awful plan when in fact there are at least a couple of decent options.

“What tends to happen,” says Clemans, “is somebody comes to me saying they’ve got a bad 401(k), and then I take a look at their materials and do a search of their funds. Almost always, we find something in there that’s appropriate.”

For instance, 61% of all plans offer a choice of index funds, most of which mirror the Standard & Poor’s 500 index of blue-chip stocks. Because they are passively managed, these funds tend to charge extremely low fees.

Now, an S&P; 500 index fund might not give you the returns of the recently hot Janus Twenty fund or an Internet stock fund. But it’s an absolutely appropriate investment, says Lee.

“What you want out of a retirement account is good, solid returns,” Lee says.

* You’re in the 28% tax bracket or lower. “If I was in the 31% bracket or higher, the deduction [for 401(k) contributions] would be too valuable to give up,” says Clemans. “In the 28% bracket, it’s a flip of the coin.”

* You’re young. The more time you have for your money to compound in a Roth, the better your chances of overcoming the disadvantage of not being able to deduct your contributions from your taxes.

Of course, depending on how bad your choices are, it could be that maxing out on your 401(k) is still the better way to go even if you do find that all the above situations apply to you. Besides, with a Roth, you can contribute only $2,000 a year. So even if your 401(k) isn’t great, you may still want to do as much with it as you can.

Maybe the best way to resolve the matter, says Lee, is to do both--maximize your 401(k) and maximize your Roth.

Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at [email protected].