Advanced Personal Finance

Most of the time when you read about 401(k)s, it’s something like, “contribute at least up to the company match,” or, “don’t put too much in company stock.” But what do you do when your company’s 401(k) sucks?

Problem: Your company doesn’t offer a match.

Solution: Contribute as much as you can to a Roth IRA, then contribute to your 401(k).

I recommend maxing out a Roth IRA before contributing to a Traditional 401(k). The reason is that Roths are funded on an after-tax basis, but you withdraw the money at retirement tax free. I believe most people will be paying more taxes in the future, so a Roth is usually the best solution.

I also recommend contributing to a Roth IRA even if your plan offers a Roth 401(k). The reason is because you can always withdraw your contribution to a Roth IRA without penalty before retirement if disaster strikes and you need the money.

After you max out the Roth IRA, go back to your 401(k) plan. A 401(k) has great tax benefits. It reduces your current taxable income. Your contributions compound tax-deferred or tax-free, depending on with type you use (Traditional or Roth). It’s also an easy, automatic way to save for retirement. A company match is nice, but it’s not the best reason to use a 401(k) to save for retirement.

Problem: Most or all of the funds offered in your plan suck.

Solution: Figure out just how bad the funds are and decide if saving outside a 401(k) makes more sense.

Great, so how do you do that?

I’d consider a fund ‘bad’ if it has higher-than-average fees for its type and middling or below returns compared to its peers over many different time periods. If just some of the funds in your plan fit that description, invest instead in the ones that are good, even if it means overweighting your asset allocation. That is, if you’re offered a good stock fund in your plan, but no good bond funds, go ahead and invest in the stock fund. Outside your 401(k), say in an IRA, you can overweight bonds to compensate.

If truly all of the funds are bad, you have to consider not contributing to the 401(k) at all. Before you do, though, consider any employer match. If you’re offered a match, you’re almost certainly better off contributing to the match maximum and investing in bad funds. That’s because the immediate 50% or 25% return a company match gives you counteracts the general suckiness of the fund you invest in. For example, if you’re offered a 50% match on contributions up to 6%, go ahead and contribute the 6%. Even if your fund returns -20%, you’re still netting a positive 30% return - great by any standard.

So what if you have the worst situation of all - the funds suck and there’s no company match? In that case, there’s a very good chance you’d be better off not contributing to the 401(k) at all. Instead, invest in an IRA. I recommend a Roth IRA, but Traditional is good, too. That way, you can choose any fund you want.

Problem: Your match is in company stock and the stock is going nowhere.

Solution: Sell your company stock as soon as you can.

In 2006, Congress passed the Pension Reform Act that allows 401(k) participants to sell company matching stock. For stock given before the law was passed, you can sell 1/3 of the total each year over three years. For future matches, you can sell immediately. I advocate selling matching stock as soon as you can anyway, but this is especially true if the stock is declining or flat.

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The Roth IRA has one distinct advantage over the newly-arrived Roth 401(k).

With a Roth IRA, you can withdraw your initial investment fee- and tax-free at any time. Not so with the Roth 401(k). You can’t withdraw your contribution to a Roth 401(k) until you actually retire.

Should you want to withdraw your contribution from your Roth IRA, simply contact the financial services company where you invest and tell them what you want to do. They’ll be able to tell you the amount you’ve contributed if you don’t remember. Let them know your intentions and they can set the whole thing up. It’s very straightforward.

Now don’t get me wrong. I love the Roth 401(k) and invest a majority of my 401(k) contributions in it. With a Roth (either the 401(k) or IRA) you get your contribution and its gains tax-free at retirement. Pay no taxes on your retirement money - awfully sweet deal if you ask me.

Most people agree, which is why you’ll continually see the advice to fund a 401(k) to the employer match then switch to a Roth IRA. I don’t completely agree, though. I think the better technique is to fully fund your 401(k) then put money into a Roth IRA.

The reason is simplicity. If you have to take two actions every year - fund the Roth IRA and modify your 401(k) contribution somewhere during the year - it’s less likely you’ll actually do it.

So when comparing directly, the Roth IRA has the distinct advantage of your being able to get at your contribution before retirement. Though I don’t recommend raiding your IRA for spending money, a Roth IRA can function as a back-up emergency fund. There are different rules for withdrawing money before retirement from a traditional IRA.

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IRAs have a key place in a good retirement plan. They can give you a tax break and grow tax-deferred (in the case of a traditional IRA) or are funded by after-tax money and are tax-free at retirement (Roth IRA). Along with the 401(k), they will likely constitute the bulk of most people’s retirement savings. They’re great vehicles for saving.

But IRAs can also be great tools for spending. If you’re buying a first home or paying for college, you can take a distribution from an IRA without the usual 10% IRS penalty. (There are also other ways to take an early distribution, but they’re much less common)

Using It For First-time Home Buying

You can use up to $10,000 in an IRA for the purchase of a first home. If you’re married, you can each take $10,000 out of your individual accounts. The home doesn’t even have to be for you - children, grandkids, and parents all apply. And the definition of ‘first-time home’ is pretty loose in my book. You can’t have owned a principal residence at any time in the previous two years. This can be particularly helpful for people in the military, for example, who have rented for a while.

Using It For School

There are obviously several rules for using IRA money for school. First, the student has to be you, your spouse or kids, or grandkids. The school has to be IRS accredited. You have to use the money for tuition and school fees.

Roths Are Different

Since Roth IRAs are taxed differently than traditional IRAs, the rules for a qualified distribution are a little different. Basically, you have to have had the Roth for five years for the distribution to be completely tax-free.  Additionally, you can always withdraw your original contribution from a Roth.

You should really try to avoid tapping your IRA for anything but retirement, but it’s nice to know you can for some big life events most people face. These rules make doing so a little less painful.

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The company I work for froze our pensions a couple of years ago. Now there’s rumor that retirees will soon lose their health benefits (these kind of rumors are almost always right). People here and elsewhere bemoan these developments and heap curses upon our executives for cheating them out of their retirement benefits.

I hate to be the one to break this to you…

Pensions and pension benefits are gone and they’re not coming back.

I don’t say this in a snooty ‘I’m saving for retirement, why didn’t you’ tone. You think I like losing money and benefits? Hell, no. I think it’s tragic. But it’s a fact.

I feel particularly bad for people around 50 in situations like this. What’s left of their pension isn’t nearly enough to live on and they probably haven’t been saving in a 401(k). If they have, those savings simply haven’t had much time to compound.

Is there any hope?

For people caught in the gap between ‘enough time to save on their own for retirement’ and ‘we got our pensions,’ there’s sadly little for them to do. Sure, there’s the catch-up provision on IRAs and 401(k)s. But there are still two problems with that - most people don’t contribute enough to get to the regular IRS maximum and even if they did, $5,000 (for a 401k) or $1,000 (IRA) more per year just ain’t that much.

For everybody else, check out this simple way to calculate if you’re saving enough for retirement. If you’re not, there’s still time. The Roth 401(k) is good for saving - use it. Put money away in your IRA. Do what you can, because relying on the promise of a pension is not a plan.

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If you have a Roth IRA, you have an emergency fund, too. See, one of the beauty parts about the Roth IRA is that you can take out the initial investment whenever you want and for any reason. You’ve already paid tax on the initial investment, so you can withdraw it without penalty. So right there you have yourself a ready-made emergency fund.

It’s not a great idea to use your Roth IRA as your primary emergency fund, though. That’s because once you withdraw that money, you can’t put it back (at least not from the original tax year). Also, it goes without saying that that money is no longer earning you anything toward retirement.

I’m not a huge fan of really large emergency funds as it is. So it’s worth keeping in mind this nice feature of the Roth IRA.

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