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I am a year out of college, and therefore, i don't have any real retirement/investment plans kicked off.

I was having a discussion with my boss, and he was making a few claims I would like to get some input on.

  1. There is no better investment than a 401k. The tax deferral will always come out ahead in the end.
  2. Hence, you should always put 15,000(max) into your 401k if you can.

My observations is that this seems like hardly enough to kill inflation. Is he right? Or are there better ways to invest?

BTW, I am already maxing out a roth IRA.

EDIT: my company does 100% matching up to 6%. I would be crazy not to take advantage of this. Thats a given. This question is suppose to concentrate on whether one should be going above and beyond this 6% up to the max contributionss

  • One question...why max out a Roth IRA instead of a traditional one? – jprete Aug 16 '11 at 20:55
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    Because of the traditional IRA's income limits. – user606723 Aug 16 '11 at 21:06
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    hmm that sounds like a strange reason to max the Roth.. I'd have said because it both grows tax free and when it is time to make withdrawals those are tax free also. In retirement that means you can be pulling from both souces (401K and Roth) but only paying taxes on part of your 'income' at that point, which can mean you more easily meet your income needs, but pay lower taxes than if you had to derive all the retirement 'income'from taxable sources. – Chuck van der Linden Aug 16 '11 at 22:40
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    The 401K is not a tax free withdrawal and neither is the IRA. However Roth versions of the IRA and 401k are tax free withdrawal (at retirement). @user606723 one reason you would not want to invest in the roth IRA is that you never know... the government could change its mind and double tax you! Better tax savings now than disappointment later :) – Adam Gent Aug 17 '11 at 1:58
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    @ChuckvanderLinden I interpreted the comment to mean: I max out a Roth IRA because my income is too high for me to contribute to a traditional IRA. – Adam Wuerl Apr 18 '14 at 3:15

11 Answers 11

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To be clear, a 401K is a vehicle, you make investments WITHIN it, if you choose poorly such as say putting all your money into company stock when working for the next Enron, you can still get hurt badly. So it is important to have diversity and an appropriate risk level based on your age, tolerance for risk, etc.

That said, as vehicles go it is outstanding, and the 'always max your 401K' is very very common advice for a large number of investing professionals, CFA's, pundits, etc. That said there are a few priorities to consider here.

First priority, if there is some level of company matching, grab that, it's hard to beat that kind of 'return' in almost any other case.

Second, since you never want to tap into a 401K (if you can at all avoid it) before you are ready to retire, you should first be sure you have a good 'emergency fund' set aside in the event you lose your job, or some other major catastrophy happens. Many recommend setting aside at least 6 months of basic living expenses.

Third, if you have any high interest debt (like credit card debt) pay that stuff down as fast as you can. You'll save a ton of interest (it's pretty much the same as investing the money you use to pay it down, and getting a return equal to the interest rate you are paying, with zero risk.. can't be beat. You'll also end up with a lot better cash flow, and the ability to start saving first and spending out of savings, so you earn interest instead of paying it.

Once you have those things out of the way, then it is time to think about fully funding the 401K. and keep in mind, since you don't pay taxes on it, the 'felt effect' to you pocket is about 80% or even less, of what goes into the account, so it's not as painful as you might think, and the hit to your take home may be less than you'd expect.

Contributing as much as you can, as early as you can also lets you benefit from the effect of compounding, and has a far larger affect on the balance than money put into the account closer to retirement. So if you can afford to max it out, I surely would advise you to do so.

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    I feel like this "far larger effect" is exaggerated because of inflation. Sure, investing 15,000 has a larger effect when I am 25 than when I am 50.. but it's also worth more when I am 25. In fact, it's worth alot more... – user606723 Aug 16 '11 at 20:22
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    +1 for Enron warning. I'd suggest first priority is to grab the match, regardless of emergency fund. Next, to pay off any higher interest debt. Then I'm lined up with you, chuck. – JTP - Apologise to Monica Aug 16 '11 at 20:27
  • inflation is a factor yes, but generally the rate of inflation is relatively small compared to what you can make long term by say investing in a good no load low cost 'total stock market' fund. The doubling rate for inflaction is far longer than the doubling rate for most decent investments other than very short term notes. – Chuck van der Linden Aug 16 '11 at 20:28
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    @user606723 - I don't think you're grasping the power of compounding. If you bought an item for $1000 in 1986, today it would cost $2059.51. If you instead invested $1000 and got a 5% rate of return annually, today you would have $3,386.35. If your rate of return is 7%, you would have $5,427.43. At 10%, you would get $10,834.71. Compounding will strongly outpace inflation. – BlackJack Aug 16 '11 at 20:31
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    The big issue with a 401k is that the investment choices within it may be poor. This is a really big factor IMHO in how much an informed investor would put in a 401k versus, for example, putting money in an IRA. – jprete Aug 16 '11 at 20:54
23

I think better advice would be always max out your 401K at least to the level that the company provides a match. For example, my company will match 50% up to 10% of your salary. Good luck finding another investment with a guaranteed immediate 50% return.

Beyond the company match, it is probably good advice to put as much in the 401K as you can afford if you aren't disciplined enough to invest that money on your own. Otherwise it depends on a number of factors as to whether it is better to invest on your own or in the company plan.

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A terrific resource is this article. To summarize the points given:

PROS:

  • Employer matches your contribution
  • Income contributed is pre-tax
  • Cheap index funds

CONS:

  • withdrawals taxed as ordinary income!
  • limited investment options

There is no generic yes or no answer as to whether you ought to max out your 401(k)s. If you are a sophisticated investor, then saving the income for investing could be a better alternative. Long term capital gains are taxed at 15% in the US, so if you buy and hold on to good companies that reinvest their earnings, then the share price keeps going up and you'll save a lot of money that would go in taxes.

If you're not a very good investor, however, then 401(k)s make a lot of sense. If you're going to end up setting up some asset allocation and buying ETFs and rebalancing or having a manager rebalance for you every year or so, then you might as well take the 401(k) option and lower your taxable income.

Point #1 is simply wrong, because companies that reinvest earnings and growing for a long time are essentially creating tax-free gains for you, which is even better than tax-deferred gains. Nonetheless, most people have neither the time nor the interest to research companies and for them, the 401(k) makes more sense.

  • Cheap index fund? I hope. Our S&P fund is .05%, not all run this cheap. By the way, many now offer a trading account, where you can invest as if it were a regular brokerage account. – JTP - Apologise to Monica Aug 16 '11 at 20:30
  • Five basis points (.05%) is a pretty good deal. by comparison if you have 10k invested, Vanguard trips into 'admirals shares' on their S&P500 fund and the expenses are .06%. while their regular 'investor shares' are seventeen basis points (.17%) – Chuck van der Linden Aug 16 '11 at 20:47
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As long as you're in a lower tax bracket - you would probably be better off paying the taxes now, and investing into the Roth IRA/401K. However, you should be investing for your retirement now, and not later, because of the compounding effect, and also you'll gain the employer matching (if available).

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    yeah the problem there is limits, you can generally put far more into a 401K than you can into an IRA – Chuck van der Linden Aug 16 '11 at 20:29
  • I meant Roth 401K. If it is available of course. – littleadv Aug 17 '11 at 0:50
  • Yeah if the 401k does a tiny dent to your taxable income than Roth is better. However if you are in the middle brackets than I have some doubts about the Roth plans. Given the current state of country can you really be sure that government will not tax that money again 30-40 years later? – Adam Gent Aug 17 '11 at 2:03
  • Roth will not be taxed, because it was already taxed, that's the whole point. As long as he's in a lower tax bracket - Roth makes more sense precisely because of that (Unless the Constitution is changed to allow changing existing contracts by the law of Congress, which is a very long stretch). – littleadv Aug 17 '11 at 9:17
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The compound interest argument is a good one. While you are young, it is important to save, since time is on your side for compounding of interest. I think the 401K is a good idea, but not for all of your savings. Think about saving a percentage of your income, but put it in a couple places. Your Roth is also a great thing, since you'll be able to remove money without paying tax again. The 401k (tax deferred) is a good idea if your company matches any of it (FREE MONEY!), and because it lowers your taxable income now, and it's taken out of your check before you see it, so you don't miss it. It's still important to save other money that you can have for ready cash (unexpected dead car, for example, or medical bills, or what have you.)

I find that I don't want to be managing my investments from minute to minute, or doing my own trades (I'd rather do other things), so I have a mix (Roth, 401k, cash savings) of automated contributions for savings, and I think hard before buying new stuff. The point is to save, and if possible, try to save at least 10% of your income.

  • Welcome - Thanks for the good answer. Please hang around and answer some more! – MrChrister Aug 17 '11 at 13:57
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First, the limit this year is $16,500, $22,000 for age 50 or older. Next, does the company give you any match? If so, how much? Some will match your deposits dollar for dollar up to a certain percent of your pay. If you make $50k and deposit say 6%, that's $3k matched by company, for example. This deposit/match is the first priority. Next, you should understand the expenses in the account. A bad 401(k) with high cost quickly negates any tax deferral benefit. The 401(k) options also may be limited, what are the choices of investments? Is your income high enough that you can save $21,500? One thought is to save enough to drop back out of the 25% bracket, and go Roth after that. This is a good balance for most.

By the way, Fairmark is a great site to see what bracket you are in. If your return is simple, you can just find your standard deduction and exemption numbers and get to your taxable income very simply. The debate of of Roth vs Pretax (for both IRA and 401(k) accounts) can get pretty complex, but I found the majority of earners falling into the "live in the 15% bracket, tops" range.

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Rule of thumb: Invest in a tax deferred account only if your marginal tax rate is higher now than it will be in retirement.

If you plan on making more taxable income in retirement than you do right now, then you should invest outside a tax deferred account.

  • What happens to 401k money that isn't used? Can this be transferred to an heir(s) without major tax implications? – user606723 Aug 17 '11 at 3:06
  • @user606723 Good question. Suggest you post that as a new question. :-) – Chris W. Rea Aug 17 '11 at 13:53
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"My observations is that this seems like hardly enough to kill inflation. Is he right? Or are there better ways to invest?"

The tax deferral part of the equation isn't what dominates regarding whether your 401k beats 30 years of inflation; it is the return on investment. If your 401k account tanks due to a prolonged market crash just as you retire, then you might have been better off stashing the money in the bank. Remember, 401k money at now + 30 years is not a guaranteed return (though many speak as though it were). There is also the question as to whether fees will eat up some of your return and whether the funds your 401k invests in are good ones.

I'm uneasy with the autopilot nature of the typical 401k non-strategy; it's too much the standard thing to do in the U.S., it's too unconscious, and strikes me as Ponzi-like. It has been a winning strategy for some already, sure, and maybe it will work for the next 30-100 years or more. I just don't know. There are also changes in policy or other unknowns that 30 years will bring, so it takes faith I don't have to lock away a large chunk of my savings in something I can't touch without hassle and penalty until then.

For that reason, I have contributed very little to my 403b previously, contribute nothing now (though employer does, automatically. I have no match.) and have built up a sizable cash savings, some of which may be used to start a business or buy a house with a small or no mortgage (thereby guaranteeing at least not paying mortgage interest). I am open to changing my mind about all this, but am glad I've been able to at least save a chunk to give me some options that I can exercise in the next 5-10 years if I want, instead of having to wait 25 or more.

  • I think the autopilot is if you are putting your money into a target retirement fund. Somebody who knows what they are doing is managing it. I wouldn't got for individual stocks, but I am fine letting an expert do it. I trust a pro to get returns over 30 years. – MrChrister Aug 17 '11 at 13:59
  • But tell that to people who lost years' worth of savings in 2008-09. Yes, they recovered some of it, but many went through a very stressful period (e.g. youtube.com/watch?v=nAHgr9dY9BU) – Chelonian Aug 18 '11 at 6:10
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While tax deferral is a nice feature, the 401k is not the Holy Grail. I've seen plenty of 401k's where the investment options are horrible: sub-par performance, high fees, limited options.

That's great that you've maxed out your Roth IRA. I commend you for that.

As long as the investment options in your 401k are good, then I would stick with it.

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I'd like to correct one slight misconception made by the OP and several answers, which is that you should always automatically max out any contribution to a 401(k) that your employer matches, on the grounds that it's "free money". The employer 401(k) match is a great deal under our current tax system, but it's not actually "free". When you participate in the employer match, you gain something and you lose something: you gain the present expected value of the employer match, but you lose the current value of the additional money that you contributed because of that match. (I'm talking about the costs and benefits of the employer match itself, above and beyond those of your own contributions in the absence of an employer match.) Whether that tradeoff is worth it depends on your time horizon, risk aversion, the interest rate, etc.

To see this, consider an extreme example in which Congress completely removed the contribution limit to 401(k)'s, and you're lucky enough to work for one of the few employers with an unlimited contribution match. In this case, the naive "free money" argument would suggest that you should continue to max out your 401(k) contributions - in other words, divert your entire income into your 401(k). This is obviously ridiculous - you'd starve to death while waiting for your "free money" to arrive.

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Definitely not. You are too young. Let me explain:

Your money will be locked up for at least 40 years, and you will have to navigate some really quirky and trap-laden rules in order to get money for simple things. Let's say you want to buy a house. You won't be able to leverage the 401K for that. College Tuition? Limits.

Your money is locked in and you may get some match, but that assumes your smartest decision at your age is to save money for retirement. At your age, you should be investing in your career, and that requires cash at hand. If you want to withdraw early you pay more of a penalty than just the tax rate.

Put differently: investing in your human capital, at a young age, can yield stronger results than just squirreling money. I'd say don't worry until you are 30.

BTW: I'm 24 now. I used to save money in a 401K for a few months, before I understood the rules. Since then, I decided against 401K and just saved the money in a bank. After a few years, I had enough to start my business :) the 401K couldn't give me that opportunity.

Further Explanation:

I am in the NYC area. Many of my friends and I had to decide between living in manhattan or choosing to live in the outer boroughs or NJ. One thing I noticed was that, while the people in manhattan were burning much more money (to the tune of 1500 per month), they were actually much more productive and were promoted more often. Having lived in brooklyn and in manhattan, even though it is less expensive, you actually lose at least an hour a day thanks to the commute (and have to deal with crap like the 6 train). Personally, after moving in, I invested the extra time in myself (i.e. sleeping more, working longer hours, side projects). Now, when all is said and done, the people who decided to invest in themselves in the short term are financially more secure (both job-wise and economically, thanks to a few bonus cycles) than those who decided to save on rent and put it in a 401K.

As far as the traps are concerned, my dad tried to take out a student loan and was denied thanks to a Vanguard quirk which didnt allow more than 50K to be borrowed (even though the account had over 500K to begin with).

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    you are encouraging him to forsake the great power of compounding. An example helps. presume a rate of return of 7% (which is not too unrealistic). person A puts in 5K a year starting at age 20, and stops at age 30. Person B, does not start till 31, but contributes the same 5K a year until age 55.. want to guess who comes out ahead at retirement age? it's never too early to start saving – Chuck van der Linden Aug 17 '11 at 7:30
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    @Foo: You are making an assumption that if you save, you will not have enough to spend on other things. Other answers have suggested that you build a surplus and then max out. Not everyone wants to start a business. The key is to plan for things you like to do, and begin saving at early age. – Dheer Aug 17 '11 at 8:33
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    a)There is no way you can disagree that someone should always use their 401k up to the company match, especially with a match like mine which is 100% up to 6%. b) The 401k isn't designed to be liquidated until after you're 60 years of age. If you're going to need the money before then.. they you shouldn't be putting it into a 401k. – user606723 Aug 17 '11 at 16:23
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    foo - as user606723 mentioned, I get a 100% match on 6% of income as well. For a $50k earner this doubles $3k/yr pretax. Most people change jobs every 5 years or so, and these funds can be transferred to an IRA. Even with tax and penalty, if withdrawn due to unemployment or emergency the net is far more than what was deposited. If done from day one, this alone may be enough to fund retirement over a full career of deposits. – JTP - Apologise to Monica Aug 18 '11 at 0:02
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    In service withdrawals are permitted only for hardship. It's not easy. My point is that giving up matched funds for the sake of liquidity is foolish. Deposit $30k (over say 5 years) and you may be out of pocket $20k after taxes. But with $60k in the account, if you are out of work, you might only pay $15k in tax and penalty. $45k net. For what it's worth, you can borrow up to 50% of the account value at very low rates. "fund at least up to the match" is a no-brainer. For me, it's tough to understand the arguments against it. – JTP - Apologise to Monica Aug 18 '11 at 3:04

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