Is contributing to 401k always is a good Idea? DD20 switched jobs to employer that only is matching contribution 100% to $2,000 She was aggressively contributing to her 401K and mega back door IRA for 18 months of employment with previous employer (matched 50% to the maximum allowed) and has six figures retirement saving at 22. Does it make sense to only contribute to matching amount with current employer and invest the rest outside of retirement accounts?
At a minimum, taking advantage of the match makes sense. Our S approach is to max out 401k yearly contribution (including match) and deposit excess in his brokerage account. For him, checking account is only for recurring bills and near term known expenses. Additionally, his 6 months safety money is held in a low yield cash account.
6 Likes
If you do the detailed math, the advantages of having a retirement fund grow tax deferred is enormous. Over multiple decades, the impact of taxes on investments is huge. The tax deferral is more important for money that is held for a longer period of time. This means that using a tax deferred retirement fund such as an IRA or 401k is more important the younger you are. Maxing out your 401k contribution when you are still in your early 20’s is a very good idea. A Roth IRA is also a very good idea at this point in a person’s life.
I would encourage your daughter to maximize their contribution to their company’s 401k. The odds are very good that in forty years they will be very glad that they did.
8 Likes
My advice is to contribute the amount that is matched. For anything more, use your own accounts to save for retirement. This way you have complete control of the rest of that money.
2 Likes
Retirement accounts do have the commonly advantageous characteristic of not paying yearly taxes on investment gains. This is most advantageous for investments that produce lots of taxable income every year, especially that which is not qualified at lower tax rates, so that this money can continue being invested over the years rather than immediately being used for income taxes. Higher yearly taxable income may also be disadvantageous for the purpose of some things that are offered up to or phased out at taxable income limits.
Of course, this may not be advantageous (or may be disadvantageous) in some cases, such as buy-and-hold a non-dividend stock, or any investment which has losses.
1 Like
Nobody knows how tax laws and rates may change so its probably best for her to hedge her bets; invest some in a taxable account, some in the 401K. As a further complication there are so many life paths for the circumstances when she would want the money that even if all tax laws & rates were rock-solid the best investment choice could still vary. As one saying goes “man plans and the gods laugh”.
A tax-efficient or tax-managed index fund in a regular account may not have a high tax drag. Since trading is reduced so are the associated capital gains; one estimate is that over a 15-year period the tax cost of Vanguard’s U.S. Total Stock Market Index Fund VTSMX was just 0.44% per year (http://performance.morningstar.com/fund/tax-analysis.action?t=VTSMX®ion=usa&culture=en_US) She may come out ahead in retirement selling VTSMX shares at capital gains rates instead of ordinary income rates which is how all 401Ks withdrawals are taxed.
Two advantages of holdings in a 401K are the ability to rebalance without any tax implications and protection from creditors. The former can be significant over time; the S&P 500 has way outperformed foreign funds the past decade or so, someone holding most funds outside a tax-advantaged account is pretty much stuck. Or as she nears retirement and wants to hold more in bonds that will be expensive to do in a regular account.
She should also look at the funds available in her current 401K to help guide her choice. An employer with a minimal program may also be a program that signed up with a provider only offering funds with high expense ratios; a little wining and dining of the HR leadership sometimes goes a long way.
Given her 6-figure holdings she should also give thought to whether she keeps the old 401K money with the old vendor, rolls it over to the new one, or rolls it into an IRA. The bulk of her holding are/were in a Roth 401k. She should confirm the rules but I think you can withdraw the principal from a Roth IRA without penalty at any time but it must be prorated with the gains (and tax paid) if it comes from a Roth 401K. This could matter is she wants the money for something like a house downpayment.
There is a Boglehead forum with lots of people that care about investing she might want to post on.
4 Likes
If she was contributing max ($19,500) plus 50% match over 18 months and has over 6 figures in her account now, her money more than doubled… that is a pretty hefty return. Was it mostly in a high-flying company stock or an aggressive stock fund? Time to diversify a bit.
The OP mentioned the daughter was using the mega-backdoor strategy which allows contributing up to an additional $38.5K in after-tax dollars to a Roth IRA or Roth 401K depending on plan rules. There are some picky details but that’s the gist of how it’s done. About 20% of employers now offer this I think I remember reading. See Mega Backdoor Roths: How They Work - NerdWallet I’ve had employers offer this thru Fidelity and it couldn’t be easier to setup.
Anyone regularly saving money into a taxable brokerage account that has this option should consider doing it instead. The money in both cases is from after-tax dollars but with the conversion it will never be taxed again as it grows.
1 Like
I highly recommend NOT doing this. Treat your retirement funds as a “sacred cow” and don’t touch them unless it is a real emergency. She can start saving for her downpayment outside of retirement funds.
4 Likes
Ah ok. Need more 
! 
Missed that part.
Still, there are companies that use their own stock as one of retirement investment choices. My advice is… remember Enron.
2 Likes
I had neighbors in the early 2000’s- he worked for Lehman, she worked for Bear Stearns. They moved out of their “starter home” to something big and expensive… and soon discovered an ugly side to “paper gains”–his money was invested in Lehman stock, and her money was invested in Bear Stearns… and property values in their fancy neighborhood dropped like a stone in 2008.
Diversification- not just a theoretical construct.
4 Likes
Thank you everyone! Very good information from very knowledgeable group. Just want to add that both employers have 401k with Fidelity and she was employed with first employer for only 18 months but maxed out her contributions for two years with full 50% employer matching. She mostly invested in index funds. And she has 401k, not the Roth.
1 Like
Smart kiddo. 
Tell her to keep it up.
2 Likes
This can’t be overstated…gains are not taxed, ever, even if it is withdrawn early and income taxes and penalty are paid. As long as the tax laws are similar, this FAR outweighs any disadvantage even if monies are withdrawn early and a 10% penalty is paid.
I do agree that saving some in a taxable account is wise, but only after fully taking full advantage of all tax advantaged options.
Great job on her part saving hard!!!
4 Likes
Diversification incudes tax diversification. I like having multiple tax structures (qualified, fully taxable and tax free). I would contribute to the 401k at least up to the match. Exceeding the match has more to do with how much cash flow you have. I would fund a Roth before contributing excess money tot he 401k (beyond match). I would also set up a brokerage account for liquidity purposes (although the Roth contributions are liquid from day 1 - no taxes or penalties - you really don’t want to touch those until 60. If you can do all that and have more left over, consider adding to the 401k.
2 Likes
For our S, we always recommend he contribute to get max employer match and the. Decide for himself where else to invest that’s tax advantaged. He has some funds in employer 403, self 401k, Roth employer 403 and also a back door Roth IRA. He’s more than a decade older than your kiddo. He diversifies mostly by using broad index funds.
2 Likes
Huh? Income taxes are taxes. Everything you withdraw from a tax advantaged account (other than HSA for health expenses) is subject to tax at income tax rates. And penalties are on top of that.
1 Like
A few thoughts:
Free money is free money. Contribute at least to an employee match.
The decision is simply a tax rate choice. Applying X dollars before tax and being taxed at a given rate in the future, and paying that same tax rate today and investing the rest to be withdrawn in the future, tax free, yield the same return.
A student just out of school is likely at a low tax rate. Certainly for the first half year, at a minimum. An after tax, Roth instrument is almost always the best choice, unless you believe that rates will significantly fall in the future.
Also keep in mind that anyone should have an emergency fund of several months of living expenses available and liquid.
3 Likes
That is a factor in choosing between traditional (tax at the back door) and Roth (tax at the front door) versions of retirement accounts. However, both accounts avoid paying yearly income taxes each year between contribution and withdrawal of the funds.
For those contributing the maximum possible, Roth does effectively allow a higher contribution if the Roth after-tax contribution limit is the same as the traditional pre-tax contribution limit (think of it in terms of the pre-tax money that is used to fund contributions).
1 Like
I wasn’t speaking of Roth vs. 401K. Both have their advantages and as you say, depend on what current tax rates are and expected future tax rates are expected to be. I’m talking about a standard brokerage account. You put after tax money in AND pay capital gains. It’s also a vehicle that has it’s place, but will give up the most to taxation. Someone who plows money into a 401K, holds it for 20 years and the withdraws early paying the penalty will have much more money that someone with the same investment in a brokerage account. As @ucbalumnus nicely summarized…