The following article was originally published at Forbes on 12/22/14.
By Robert Schmansky, CFP®
A rule of thumb that savers are often advised to adhere to is that it is important to maximize contributions to workplace retirement planbefore considering investing elsewhere.
This advice does have its merits. Workplace retirement plans enjoy higher contribution limits than IRAs or Roth IRAs. Savers are often phased out of tax benefits from those accounts due to income levels, and the workplace plan may be the only place to save. Workplace plans often come with matching contributions as well that should be taken advantage of.
There are times, however, when you may be better off saving for retirement outside of your plan first, or at least not contributing more after capturing the maximum amount of an employer contribution. Retirement investors should be aware of all of their options for tax-advantaged retirement savings, and weigh the pros and cons of each before proceeding.
Below are four scenarios in which putting all your chips on your 401(k) plan might not be the best approach:
1. Your company’s 401(k) has a low (or no) matching contribution rate, and offers limited investment choices.
Investment choices and asset management fees can vary dramatically based on the amount of assets held across the entire plan, and whether the fund menu is comprised of more actively managed or passive stock index funds. A “vanilla” indexed U.S. stock fund could carry annual expenses below two tenths of a percent, whereas an actively managed fund could cost as much as ten times that amount.
Very often, a plan limits the ability to diversify into asset categories that can add to long-term returns in asset classes such as mid andsmall-cap domestic, international, and emerging markets funds. Especially if you have a few decades to invest, having a tilt away from domestic large caps can add several percentage points to your annualized returns over time.
The combination of these two factors can make a material difference on your long-term results.
To illustrate the point, let’s say you make $50,000 and receive a 25% match on up to 6% of salary contributed to the plan. You contribute $3,000, and you receive $750 in a match for a total of $3,750 inannual contributions. If between high costs and inability to diversify you trail what you would have earned in an IRA by 2 percentage points after 20 years, you would do better not receiving the matchand investing in your own IRA.
Keep in mind your results will be better if you receive a higher matchpercentage, or if you have a shorter time horizon. However, for thosewith time or with a lower or non-existent match, weigh your ability to diversify and keep your costs low within your employer’s plan before deciding it is worthwhile.
2. Your plan has high expenses. Asset management fees aren’t the only bite taken out of many workplace retirement plans. Recordkeeping and TPA fees can also take a toll, and may add another percentage point or more to the annual charge against your investment earnings. In contrast, most IRA providers today have very low if any administrative charges.
If you work for a small employer, chances are the total 401(k) fees are higher since there are fewer employees and a smaller assets pool to defray fixed expenses. Since plan expenses are typically taken out of your investment returns, the effect is the same as illustrated in the high investment management fee example above.
Look to lower your expenses by using index investment options, and check if your plan offers a self-directed brokerage account where you can select more than the limited menu or funds, or allows for in-service withdrawals on any portion of your account to rollover to an IRA.
3. You don’t expect your tax bracket to fall (or fall much) in retirement. If your tax bracket won’t be lower in retirement, you may not benefit from your pre-tax 401(k) contributions.
Don’t think that happens often? I meet many in retirement who pay as much (and in some cases more) in retirement due to pensions and Social Security.
If you are in the 15% marginal tax bracket, you have the most options to consider, all else being equal. And it could be that paying taxes today is your best bet.
If you are single, have no children, and take the standard deduction your adjusted gross income (AGI) is $47,050 or less, you are in the 15% tax bracket. If you are married without kids taking the standard deduction, you’ll be in the 15% bracket or below if your AGI is less than $94,100. With children or if you itemize deductions, the threshold will be higher.
The reason that pre-tax 401(k) contributions may not be best for you is that tax-deferral is beneficial if you pay a lower marginal tax rate when you make withdrawals than you would otherwise pay on those extra earnings today. In the 15% bracket or even higher, you may not be paying less in the future. Saving in a Roth IRA with after-tax dollars but tax-free when withdrawn, or taxable accounts utilizing tax-managed equity mutual funds, you will benefit by paying a low tax rate on your salary today, and potentially never worrying about taxes on that money again.
One of the reasons most simply assume we will be paying less in retirement is that they will not have wage income. However, every dollar withdrawn from pre-tax savings is taxed like wages as ordinary income, and when certain income thresholds are passedthere are other taxes to consider, the most common is Social Security becomes subject to tax. Most of the current retirees I work with are paying much more than 15% on the margin when factoring in taxes on their Social Security benefits whose thresholds were never indexed for inflation. (Today the IRS defines the “substantial” amount of income that triggers this tax as $25,000 for individuals and $32,000 for married filing jointly).
As referenced above, one additional place to avoid future taxes is in a tax-efficient equity mutual fund. Long-term capital gains and qualified dividends are currently taxed at 0% for taxpayers in the 15% bracket. Even if you experience an increase in brackets, your tax rate will most likely only rise on that income back to 15%, which still may benefit you to invest with after-tax dollars today.
Another way to look at the after-tax contribution strategy is simply that you are locking in today’s known tax rates in lieu of gambling on future rates.
4. Your spouse doesn’t have access to a 401(k). If you have an employer plan but your spouse does not, you may also benefit from saving to a “Kay Bailey Hutchison Spousal IRA” before your 401(k).
If your modified adjusted gross income (adjusted gross income with add backs for foreign earned income, student loan interest, and other items excluded on your return) is below $181,000 for 2014, you may contribute to an IRA for your spouse and receive a full deduction. If you are above the company match, a spousal IRA gives you the same tax benefits with more investment control.
The above reasons may not trump the benefits of investing in a 401(k). An updated rule of thumb may be to take full advantage of the employer match if your plan fees are reasonable. Next, consider your options for saving to Roth, spousal, or traditional IRAs. Finally, weigh the costs and options in your 401(k) before assuming it makes sense to maximize your contributions versus taking advantage of the diversification and capital gains tax benefits of a taxable account.