When NOT to put money in your 401(k)

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The twin advantages of tax deferral and a corporate match make the 401(k) the foundation of most people's savings plan. Putting in enough to get the maximum corporate match is almost always the right choice--a good corporate match is so much money, funding your 401(k) usually even comes ahead of paying off debt. Sometimes, though, it makes sense to put money other places.

Here's a quick ordering that makes sense for a wide range of financial situations, followed by a look at some special situations that can influence your choices. Of course, all this is after you've housed, clothed, and fed your family, and paid your bills.

Minimum payments on debts. It would be dumb to ruin your credit while putting away money for retirement.

401(k) to the limit of the corporate match. The only time you wouldn't go for the full match would be if the match were lousy or you had debt at really high interest rates. If the corporate match is 50% but your payday loan is costing you 56%, then pay off the payday loan. If it's going to take more than a year to pay off your debt, then you have to do some arithmetic to compare the interest rates, because you only get the match in the first year. If, for example, you're going to be paying off debt for three years, and your corporate match is 100%, then you'd want to pay off any debt where the interest rate is over about 33% before you started funding your 401(k).

Accelerated payments on debts. Once you're grabbing the full corporate match, go ahead and apply additional money to paying off debt. The exception would be debts with low, fixed interest rates (mortgages and student loans often fall into this category).

A Roth IRA. If you're getting the full corporate match on the 401(k) and you still have some money available to invest, I'd put it into a Roth IRA. You don't get a tax deferral, but your earnings are tax-free forever. The earlier you start maxing out your Roth, the more earnings you'll have that you never have to pay taxes on. Go ahead and max out your spouse's Roth IRA as well.

Up to this point, it's really pretty straightforward--those choices are right for the vast majority of people. If you've made it to this point, though, and you've still got some money to invest, you've got a real decision to make.

Conventional wisdom at this point would be to max out your 401(k)--bring your contributions up to the maximum your employer allows. (There's also an IRS limit.) Depending on your tax situation and your plans for the future, though, I'd like to suggest an alternative: regular savings and investments.

The advantage of maxing out the 401(k)--tax-sheltering that much more of your current income--are clear. But you've already deferred a bunch of taxes, plus you've arranged for some permanently tax-free earnings. Whether tax-sheltering further income makes sense is worth considering carefully.

First, does tax-deferral make sense? Only if your future tax rates will be lower than your current tax rates. Tax rates now are about as low as they've been for a long time. I think there's a significant chance that tax rates in the future will be higher--enough of a chance that, with a portion of your savings, I think it's perfectly reasonable to pay taxes now, at the current rates, rather than pay it later at whatever the rates will turn out to be.

Second, when are you going to want the money? Even though it's possible to borrow money from a 401(k), if there's any significant chance that you'll want the money before retirement, you're probably better off keeping the money out of any of these tax-deferred plans. So, if you're saving for a new car or a new house or any other major purchase, it can make sense to just invest the money in an internet savings account, short-term bond fund, or some other reasonably liquid investment with a time horizon that matches when you're going to want the money.

In particular, if you're saving with a plan to retire early (before age 59), you probably want to accumulate significant savings outside of a retirement account.

It's possible to tap an IRA before age 59½. It's even a reasonable thing to do, if you're actually retiring. You have to follow some complicated rules whereby you take out money at a rate that will make the account last the rest of your life, according to the IRS estimate of your life expectancy. Once you start, you have to continue for at least 5 years. If you take out the wrong amount, then all the withdrawals turn into early withdrawals and you have to pay the 10% penalty. And, even if you follow all the rules, it's still income that you need to pay taxes on.

I think it's perfectly reasonable, once you've tax sheltered a goodly sum, to just pay the taxes on the rest of your income now, invest, and then own it with no deferred tax liability in the future.

Remember that your money is fungible, so the goals that you have for your money shouldn't be influenced by the names of the compartments where you keep it. Money in a retirement account supports all your financial goals, as does money in a brokerage account, a college savings plan for your kids, etc. If you're putting money into a 529 plan before you're getting the full employer match on your 401(k), you're not increasing the chance that your kids will be able to go to college, you're just making your whole family's financial future less secure. All your investments support all your financial goals. Chose the compartments you keep the money in to maximize your total savings after-tax; don't be distracted by what the plans are called.

An additional reason that I suggest using a mix of 401(k), Roth IRA, regular IRA, and plain old after-tax savings and investments, is that the government can change the rules on these tax-favored plans at any time. There are so many voters in each of these plans now that it would probably be political suicide to try to eliminate them, but politicians always want to get their hands on any money that they can. Between now and when you retire, there very well might be a point where a political consensus emerges that some crisis is so severe as to make people's retirement savings fair game. Best if your money is spread around a bit, so that you're less likely to get bit with the full force of whatever money grabbing the politicians end up with, since they're liable to grab at different plans differently.

Of course, one big win of a 401(k) is that you definitely do save the money. If there's any chance that some of that extra savings won't actually get saved if it doesn't go into the 401(k), then stick with the 401(k). The tax saving of a 401(k), together with the option to borrow money from the plan, means that it's never going to be the wrong choice for saving. The reasons to go ahead and save some money outside the plan are real enough under some circumstances (if you're going to use the money before retirement, and especially if you're already paying taxes at a fairly low rate), but they're small. It matters far more that you actually save the money than it does where the money gets saved.