How much, if anything, should you invest in your 401(k)?

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Successful stock investors think of themselves as business owners: They want to own companies that have defensible franchises--or moats--and they want to own them at the right prices.

The concept of business ownership is useful when it comes to your household's financial management, too. As with managing a business, your guiding principle should be to deploy any investable assets into those opportunities that promise the highest rate of return and steer clear of investments that don't.

One of the first major capital-allocation decisions confronting many investors is how much to steer toward their 401(k)s (or 403(b)s or 457s, depending on their type of employer). The vehicle carries many advantages, including potential employer matching contributions, tax benefits, and perhaps most significantly, a fairly painless and disciplined way to save for retirement.

Yet maxing out a 401(k) isn't necessarily the best use of everyone's cash. The decision about whether to do so depends on your own personal choice set. Answering the following questions, in roughly the same sequence, can help you arrive at the right solution.

Do you have high-interest consumer debt?
If yes, paying it off as soon as possible is the right answer, as your investments are unlikely to out-earn the interest rate. If no, investing in a 401(k) or other retirement vehicle looks like a good bet.

Are you receiving matching funds on your 401(k) contributions?
If so, contributing enough to the 401(k) to meet the match is an obvious answer. If not, you're better off seeking other options--such as investing in an IRA--for any investable dollars above what you need to contribute to earn the match.

How good is the 401(k) plan?
If it's a solid plan with very low costs, you can safely use your 401(k) as your main investing vehicle. If it's lousy and you're not earning matching funds, you have good reason to invest outside of the plan, either in an IRA or even within a taxable account.

Are you able to obtain comparable tax benefits by investing outside of the 401(k)--for example, in a traditional deductible or Roth IRA?
If similar tax-efficiency characteristics can be simulated in an IRA--for example, if your 401(k) is weak but you can contribute to a deductible IRA--that argues against maxing out the 401(k).

How much do you need the discipline?
Be honest. If you're not a disciplined saver, the ability to automate your contributions, as is easy to do in a 401(k), can make it a sensible retirement vehicle, even if your particular plan isn't best of breed.

How much money do you have to invest?
If you're in a position to make the maximum allowable contribution to an IRA and a 401(k), and perhaps to invest in a taxable account to boot, that's a good argument for taking full advantage of tax-sheltered vehicles, even if your 401(k) has shortcomings.

What sort of asset allocation do you expect to maintain? What's your investing time horizon?
If it's particularly mild-mannered and your projected returns are pretty low, debt paydown--even of fairly low-interest mortgage debt--is often a better strategy than investing in the market, because your debt-retirement return is guaranteed. Moreover, the shorter the time horizon, the less one will tend to benefit from saving inside of a tax-sheltered account.

Do you have any other debt--mortgage debt or student loans, for example? Are you earning a tax deduction on your interest? Are you paying private mortgage insurance?
Earning a tax deduction makes prepaying the debt, provided the interest rate is moderate, less urgent. Paying PMI, on the other hand, makes it a bigger priority to pay down the mortgage to the point that you can get rid of that extra PMI expense.

Are you apt to be in a higher tax bracket today than in the future, or vice versa?
The former situation argues for making deductible contributions to both IRAs and 401(k)s, because the tax break is more valuable today than it will be in the future. Roth contributions, by contrast, are preferable if you think you'll be in a higher tax bracket in the future. Splitting contributions between both account types makes sense if you're not sure.

Let's look at a few sample scenarios to see how all of these factors come together in practice:

Example 1: A 28-year-old investor comes out of grad school and lands his first job. He researches his new employer's 401(k) plan and finds that he'll pay 0.60% per year in administrative costs, and most funds charge at least 1.25% to boot. His employer is matching him on contributions of up to 3% of his $25,000 salary. He also has $11,000 in credit card debt at an interest rate of 17.9%.

Capital Allocation Strategy: In this instance, his best bet is to steer 3% of his salary into the 401(k) plan to earn any employer matching contributions, because he'd be hard-pressed to earn a 100% return on his money anywhere else. After that, he should turn his attention to wiping out his credit card debt, because the return on his investments will never beat that kind of APR, at least not year after year. If he still has money to invest after tackling those two tasks, he can think about contributing to a Roth IRA, which gives him a lower-cost avenue to retirement savings than his 401(k) affords him.

Example 2: A 45-year-old IT specialist earning a salary of $170,000 can steer about $30,000 per year toward her retirement savings. Her company retirement plan doesn't offer any matching contributions, but nor does it have any administrative expenses, and it features a suite of ultra-low-cost index funds. Her 401(k) plan also enables her to make Roth contributions. She has a high risk tolerance and capacity, typically holding about 80% of her portfolio in stocks, and has already amassed a $1.2 million retirement nest egg in her traditional 401(k). Her sole debt is a $90,000 mortgage on a condo; it carries an interest rate of 3.25%.

Capital Allocation Strategy: Given the large amount this investor can sock away each year, she'd do well to take advantage of all of the tax-saving vehicles she has available to her. Thus, even though this investor isn't earning matching contributions, making the maximum allowable contribution to the Roth option in her 401(k) makes sense. She can then make a full Roth IRA contribution after that (using a "backdoor Roth IRA"), and invest any additional monies in tax-friendly investments inside of a taxable brokerage account. Steering new contributions to Roth rather than traditional retirement accounts will help her build a tax-diversified cash flow in retirement, since she already has significant assets in her traditional 401(k). Prepaying her mortgage isn't a huge priority given that she's likely to out-earn her interest rate over time with her aggressively positioned portfolio; she may also be receiving a small tax break on her mortgage interest deduction.

Example 3: A 62-year-old health-care professional earning $45,000 per year hopes to retire within the next five to seven years. Her 401(k) plan offers a matching contribution, but the investment options are only so-so. She has amassed some assets for retirement in conservative funds held within a rollover IRA and in her 401(k), but expects that Social Security will fund a big share of her modest living expenses once she retires. She has about $30,000 left on her 4% mortgage and looks forward to the day when she won't have much in the way of housing expenses.

Capital Allocation Strategy: Here again, funding the 401(k) up to the amount she needs to contribute to earn the match is a good first step. Steering any additional investment assets to pay down the mortgage looks like a smart next move, particularly given that she's close to retirement, her mortgage interest deduction isn't likely saving her a lot of money, and she's unlikely to out-earn her mortgage interest rate on her conservatively positioned investments.

 

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