401K Plans

Personally I think the 401K is the greatest thing since sliced bread. It’s one of the few legitimate ways you can reduce the taxman’s bite. And yet many people still don’t participate. Why is that?

Participating in a 401K allows you to defer taxes on your contributions. Even better, many companies will match some portion of your contributions, typically up to about 3-6% of your pay. That’s free money you’re throwing away if you don’t participate. Some companies will make a small contribution on your behalf even if you don’t participate, but even then you’re still missing out on most of the employer match.

Some people claim that putting your money into a (Roth) IRA is a better investment than a 401K. But there’s no reason you can’t do both; first put enough money into your 401K to get the full company match, then put the rest into a (Roth) IRA.

For instance, say your employer matches 50% of your contributions up to 6% of your salary. In that case you should contribute at a 6% rate to get the full 3% company match, then start putting any extra money you have left over into your IRA. And remember, you can always roll your 401K over to an IRA when you leave you current company.

Another anti-401K argument is that when you start drawing on a 401k in retirement you’ll pay taxes on your withdrawals at regular income tax rates (perhaps 28% or so), whereas if you invest in a taxable mutual fund instead, you might only pay 15% on long term capital gains over the years and nothing on the withdrawals. But this argument ignores the tax-free compounding aspect of a 401K. Also, if you put money in a mutual fund you’re paying taxes twice: first in your regular payroll taxes, and then again in the 15% capital gains taxes.

Given these benefits of 401Ks then you can see why I’m amazed that some people still don’t participate. Certain companies have taken the initiative to automatically sign up new employees for 401Ks without requesting their permission. But while I’m a big supporter of 401Ks, I have a hard time agreeing with this approach. It smells too much like Big Brother to me.