Q. Financial advisors often recommend maximizing 401(K) contribution. I wonder when is not a good time to save 401(k) money?
A. We talked about the flaws of 401(k) in this blog post. Now I will discuss a few situations saving for 401(k) is not ideal:
Situation 1. If your future tax will stay the same
Basically, if your tax rates remain the same, a regular 401(k)—with or without matching—always beats investing in a taxable account, thanks to its tax advantages.
An example
Suppose your current and future rates for ordinary income and capital gains are 25% and 15% respectively. Further, suppose that you can either invest $100 in an IRA or $75 in taxable account. Assume that the stocks return in appreciation and dividends 10% in the first year. In the IRA, you have $110. After paying $27.50 in taxes, you will have $82.50 after-tax money.
In the taxable account, you invested $75 after paying $25 in taxes. If you pays $1.13 in taxes on the gain and dividends of 7.50, your are left with $81.38. Although you will pay more in taxes with the IRA ($27.50 instead of $26.12), you will be left with more ($82.50 instead of $81.38). The additional accumulation increases with longer horizons and higher tax rates on assets in the taxable account.
Situation 2. If your future tax will increase
It's a no brainer in this situation - if your future tax rate will be higher, you don't want to contribute to 401(k) which gives you less tax benefits now.
Situation 3. If you need access to the money before retirement time
401(k) account comes with the IRS-mandated early withdraw penalty. However, if you contribute to Roth 401(k) or a Roth IRA (if you quality), you can withdraw contribution penalty free.
Situation 4. You don't want to take money out of 401(k) later
401(k) account comes with IRS-mandated required minimum distributions (RMDs). The IRS requires you to take RMD when you reach age 70½. You may, for example, wish to self-fund long-term care and will want to keep aside a significant stockpile of assets to fund that potential liability. If your money is in a Roth IRA account, there is no such RMD requirement.
Situation 5. You don't have employer match and faces hefty 401(k) account fees
If you don't get any employer match and the fees and fund choices of your 401(k) account are prohibitive, it's probably more economical to contribute to an IRA account.
A. We talked about the flaws of 401(k) in this blog post. Now I will discuss a few situations saving for 401(k) is not ideal:
Situation 1. If your future tax will stay the same
Basically, if your tax rates remain the same, a regular 401(k)—with or without matching—always beats investing in a taxable account, thanks to its tax advantages.
An example
Suppose your current and future rates for ordinary income and capital gains are 25% and 15% respectively. Further, suppose that you can either invest $100 in an IRA or $75 in taxable account. Assume that the stocks return in appreciation and dividends 10% in the first year. In the IRA, you have $110. After paying $27.50 in taxes, you will have $82.50 after-tax money.
In the taxable account, you invested $75 after paying $25 in taxes. If you pays $1.13 in taxes on the gain and dividends of 7.50, your are left with $81.38. Although you will pay more in taxes with the IRA ($27.50 instead of $26.12), you will be left with more ($82.50 instead of $81.38). The additional accumulation increases with longer horizons and higher tax rates on assets in the taxable account.
Situation 2. If your future tax will increase
It's a no brainer in this situation - if your future tax rate will be higher, you don't want to contribute to 401(k) which gives you less tax benefits now.
Situation 3. If you need access to the money before retirement time
401(k) account comes with the IRS-mandated early withdraw penalty. However, if you contribute to Roth 401(k) or a Roth IRA (if you quality), you can withdraw contribution penalty free.
Situation 4. You don't want to take money out of 401(k) later
401(k) account comes with IRS-mandated required minimum distributions (RMDs). The IRS requires you to take RMD when you reach age 70½. You may, for example, wish to self-fund long-term care and will want to keep aside a significant stockpile of assets to fund that potential liability. If your money is in a Roth IRA account, there is no such RMD requirement.
Situation 5. You don't have employer match and faces hefty 401(k) account fees
If you don't get any employer match and the fees and fund choices of your 401(k) account are prohibitive, it's probably more economical to contribute to an IRA account.
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