When a 401(k) Doesn't Make Sense
Tim Middleton over at MSN Money wrote a good article about when you should ditch your 401(k). The whole article is worth a read, but his arguments come down to this:
*More and more companies are reducing or eliminating the match
*The investments in many plans (especially those for smaller companies) are too expensive, too limited, and too lousy
*You'll have far more flexibility with an IRA, though you can't contribute as much ($5,000 in 2009, an additional $1,000 if you're 50 or older) and higher-income workers might not get all the tax breaks.
I agree. While Middleton covered the biggest reasons to avoid your 401(k), I'll add a few other, lesser scenarios to consider, which might push you one way or the other if you're on the fence.
You're only eligible for a traditional 401(k). Distributions from a traditional 401(k) are taxed as ordinary income, whereas long-term capital gains are taxed at lower rates (and these days, most of us need the long term to see capital gains). On the other hand, contributions to a 401(k) are essentially tax-deductible. So it's a question of when you want your tax break. Some investors might want to take the bigger tax hit now, especially if they think their tax bracket will be higher in retirement.
You love tax-loss harvesting. You can't take a deductible capital loss on investments in retirement accounts, whereas you can in a regular brokerage account. That capital loss can be used to offset capital gains and, if you have any left over, up to $3,000 of ordinary income each year (losses can be carried forward to subsequent years indefinitely). For some investors, the ability to offset gains and income with losses, combined with the lower tax rate on long-term capital gains, makes some sense. At the very least, this can offset to some degree the tax break you give up by not contributing to a 401(k), and you get a lot more investment flexibility. (However, if you're eligible for the Roth IRA, definitely max that out first.)
You might need the money before age 59 1/2 or before you retire. Generally, you can't touch money in your retirement accounts before age 59 1/2 without paying a 10% penalty. There are some exceptions. Perhaps the least-known is the ability to take out contributions to a Roth IRA any time, tax- and penalty-free (earnings may still be subject to penalties and earnings, depending on your age and how long the account has been open). Of course, retirement savings are for retirement, but some folks value the extra flexibility of the Roth IRA.
Here's the bottom line: If you're still receiving a decent match and you'll be at your company long enough for it to vest, then it's likely best to contribute to the point where you receive the full match. Beyond that, you might want to choose an IRA, especially if you're eligible for the Roth IRA. If you're not eligible for a Roth, then it still might make sense to invest outside of your employer-sponsored plan.