When Is Putting Money in Your 401(k) a Bad Idea?

The benefits of tax deferral and corporate matching make the 401(k) the foundation of most people’s retirement plans. Putting in enough to get the maximum corporate match is almost always the right choice, and funding your 401(k) usually even comes ahead of paying off debt. But sometimes it makes more sense to put money other places.

For most financial situations, the following priorities should take precedence over contributing to your 401(k). Of course, all this should come after you have taken care of the basic necessities to support your family.

1. Minimum Payments on Debts: It would be unwise to ruin your credit while putting away money for retirement.

2. 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 poor or you had debt at really high interest rates. 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.

3. Accelerated Payments on Debts: Once you’re receiving the full corporate match, apply additional money to pay off old and current debts. The exception would be debts with low, fixed interest rates.

4. Roth IRA: If you’re getting the full corporate match on the 401(k) and you still have some money available to invest, consider a Roth IRA. Your earnings in a Roth IRA are tax-free forever, and the earlier you start maxing out your Roth, the more earnings you’ll have that you never have to pay taxes on.

The preceding choices are right for the vast majority of people. But if you’ve still got some money to invest, there are even more decisions ahead.

While maxing out your 401(k) is a fair option, depending on your tax situation and your future plans, you may want to consider regular savings and investments.

The advantages of maxing out the 401(k), such as tax-sheltering more of your income, are clear. But you’ve already deferred a lot of taxes and 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.

Second, when are you going to want the money? 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 any tax-deferred plans. It can make sense to simply invest the money in a savings account, short-term bond fund, or some other liquid investment with a time horizon that matches when you’re going to want the money.

An additional reason to use a mix of 401(k), Roth IRA, regular IRA, and after-tax savings and investments, is that the government can change the rules on these tax-favored plans at any time. It is best if your money is spread around, so that you’re less likely to suffer from any political decision that puts your retirement savings at risk of being raided by taxes.

Of course, with a 401(k), 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), stick with the 401(k). The tax savings of a 401(k) means that it’s never a bad choice for saving. The reasons to save money outside the plan are relatively few but should still be considered under some circumstances.