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Maxing Out a 401(k) Is Not Always a Client's Best Bet

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A little more than half the nation’s civilian workforce is contributing to a defined contribution plan, according to the Bureau of Labor Statistics. While many advisors are pushing for greater participation rates, however, the 401(k)—the most popular employer-provided option—may not be the best bet for many clients. While at least matching employers’ contributions is an obvious choice for most planners, many experts strongly advise their clients to avoid maxing out their 401(k)s, at least until they’ve allocated funds to a variety of other assets.

Why isn’t the 401(k) the best investment vehicle for some pre-retirees? “It does have a higher limit than the IRA, but there are usually limited investment options, and the fees can be very expensive,” said Dan White of Daniel A. White and Associates. “Those fees add up to a lot of money over a lifetime of savings – up to tens of thousands of dollars.” While investors often refer to past returns of both specific investments and 401(k)s in general, previous performance is no guarantee. No matter the return, though, those fees will still apply, he said.

The combination of limited payouts and market dependence also makes the 401(k) a far riskier choice than annuities and other guaranteed income sources. “People with most of their money in a 401(k) have to live on it, but it’s hard to tell how much they can withdraw safely, and they have to worry about another 2008 situation,” said White. “They either hoard cash or don’t do the things they want to do in retirement, or they spend too much too early and have to live more conservatively than they’d planned.” On the other hand, an annuity with a guaranteed income rider might generate a payout in the neighborhood of six to seven percent, according to White, and buyers can depend on those payouts for the rest of their lives.

Despite these downsides, some advisors still recommend calculated 401(k) contributions as part of a diversified retirement strategy, rather than simply maxing them out or automatically raising contribution amounts as income allows. “We recommend our clients split their long-term investment dollars fifty-fifty between retirement plan contributions and taxable investments,” said Randy Brunson of Centurion Advisory Group. “That retirement plan portion should be combination of 401(k), IRA and perhaps Roth contributions.” Those taxable investments give pre-retirees a “base” of more liquid assets that can be used for home purchases, cars and even business investments, while the retirement plans still offer tax-deferred income later on.

Aside from investing in alternate retirement income vehicles, others still recommend an entirely different approach – paying down debt before making those investments at all. “When someone pays off a credit card, that’s a guaranteed return, and in most cases there are no guaranteed returns with 401(k)s,” said Bob Marette, author of How to Get Out of Debt in 5-7 years, Including Mortgage. “There are cases where I recommend people even pull money out of their 401(k). They’ll pay taxes but no penalties, and all that money that was going into their mortgage they can eventually put back into their 401(k). For most of Marette’s clients, holding off on retirement account investments until they’re debt free actually allows for a much higher net monthly paycheck in retirement – despite the lower total payout from the 401(k).

For clients who are already allocating too much to a 401(k), and not enough to debt, taxable investments or other assets, a simple change of course is usually the best way to move forward. “You don’t want to question clients’ decision-making abilities with a rollover. I just suggest that we change allocation of cash flow starting now,” said Brunson. White agreed, citing the 401(k)’s 10 percent early withdrawal penalty – a penalty that doesn’t apply to IRAs. Roth rollovers can also be extremely costly, since they essentially require the investor to voluntarily pay more taxes.

Finally, there are still a few situations which still warrant maxing out a 401(k). Younger workers in lower tax brackets might want to opt for Roth contributions, but older, higher income earners will likely gain more by deferring those taxes until retirement. For a pre-retiree who’s in a high tax bracket, whose employer offers a contribution match and who has enough money to max out a 401(k) and invest comparably in taxable assets, it could be a great option.