Being advised to max out your 401(k)is Personal Finance 101. But is that universally solid guidance?
Tax-sheltered retirement plans offer the convenience of automatic investments and tax breaks—pretax contributions and tax-deferred compounding for traditional 401(k)s and tax-free compounding and withdrawals for Roth contributions.
But the availability and quality of the 401(k) are also important considerations.
Some workers don’t have access to an employer-provided retirement plan, and 401(k) quality can be uneven. High administrative costs, meager employer matching contributions, and costly investment lineups can detract from 401(k)s’ tax-saving features.
Meanwhile, the tax efficiency for investors’ nonretirement accounts has improved over the years.
Broad market equity exchange-traded funds have dramatically reduced the tax drag for taxable accountholders, effectively simulating the tax deferral that comes with investing in a 401(k). And many robo-advisors use other techniques to reduce the tax drag on investors’ taxable accounts—specifically, selling losing positions to offset gainers elsewhere in investors’ portfolios. That can reduce the capital gains taxes on positions when they’re eventually liquidated.
Even as investing in a taxable account has grown more attractive, it’s a given that investors should put enough in a 401(k)—even a poor one—to earn matching contributions. If the 401(k) plan is weak and they have additional retirement assets to invest, they should opt for an IRA in lieu of steering more money to the poor 401(k) plan. Income limits apply to IRA contributions, but anyone can invest in a Roth IRA through the “backdoor,” provided they have earned income to cover the contribution amount.
Multiple Factors Determine Whether a Taxable Account Can Beat a 401(k)
But what if they have additional retirement assets to invest? Once the IRA is fully funded, would those dollars be better off in a weak 401(k) or in a brokerage account held outside a tax-sheltered account?
The answer here, as with so many financial questions, depends on a couple of key factors, especially the following:
Taxable Account vs. 401(k) Takeaways
Investors would do well to weigh their own personal tax situations—both current and future—as well as the quality of their 401(k)s when determining which account types to fund. Investors can also benefit from tax diversification—splitting assets across accounts with varying tax treatment, whether tax-deferred, taxable, or Roth—when saving for retirement.
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This article was provided to The Associated Press by Morningstar. For more personal finance content, go to https://www.morningstar.com/personal-finance
Christine Benz is Morningstar’s director of personal finance and retirement planning.
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