Financial planners typically recommend that people save more for retirement in their 401(k). There are lots of reasons that this is usually good advice, such as the tax benefits, the convenience of payroll deductions, and maybe an employer match. But can it ever make sense to reduce your 401(k) contributions?
We recently received a question from someone in which the answer to that was arguably yes. This individual was contributing about 9% of his salary to a Roth 401(k) that his employer was adding another 6% of his income to in matching contributions. Since he was contributing a decent amount, was invested fairly aggressively, and had 30 years until he planned to retire, our retirement plan estimator calculated that he was actually saving more than he needed to meet his retirement goals.
However, his financial picture wasn't all as rosy as it seemed. First, he had some debt at 12% interest. Second, he had almost no savings for an emergency, despite being practically the sole breadwinner of his family (his wife earned a very meager salary working part-time). If he were to lose his job or face another financial hardship, he would have trouble paying the bills. Finally, he was renting and wanted to buy a bigger home in a few years for his growing family but didn't know where he was going to get the down payment.
While his 401(k) plan allowed him to take hardship withdrawals or loans, each has their downsides. Hardship withdrawals are only for limited purposes and are subject to taxes and possibly a 10% penalty. Loans are limited to 1/2 of his vested account balance and need to be repaid.
After discussing his situation, he decided to reduce his 401(k) contributions to the 6% he needed to get the full match from his employer and to put those savings towards paying off his debt and contributing to a Roth IRA instead. Our retirement calculator showed that he would still be on track to retirement with the lower 401(k) contributions. Paying off the debt made sense because even with the tax benefits, he was unlikely to earn as much in his 401(k) as the 12% that his debt was costing him. As for the Roth IRA, it provided the same tax-free benefits after age 59 1/2 as his Roth 401(k) but with two additional advantages:
Roth IRAs allow you to withdraw the contributions tax and penalty-free at any time and for any reason. You may need to read that again because even some financial advisers aren't aware of this. Let's say that he contributed the maximum $5k per year to a Roth IRA for 3 years and it grew to about $17,500. At that time, he could withdraw up to the $15k he contributed for any reason without having to pay a tax or penalty on it. Only if he withdrew the earnings would he have to pay a tax and possibly a 10% penalty on that extra $2,500 but all the contributions are withdrawn first. This means that his Roth contributions are easily available and can be considered part of his emergency fund.
If used for a "first-time" home purchase, Roth IRA earnings can be withdrawn penalty-free and even possibly tax-free. Let's say that after 5 years, his Roth IRA has grown to about $32k, he was able to accumulate 3-6 months of expenses for emergencies outside his Roth IRA, and needs some money for a down payment. He can still withdraw his $25k in contributions tax and penalty-free. In addition to that, he can withdraw up to $10k of his earnings ($7k in this case) penalty-free to buy a home as long as he hasn't owned one in the last 2 years (that's how they define "first-time home purchaser" because "haven't owned a home in a while purchaser" was too much of a mouthful even for the IRS). Since he had the account for at least 5 years, these earnings would also be tax-free. Pretty nifty, huh?
(By the way, none of these advantages will do you much good if your account balance falls in value just when you need it. If you intend to use your Roth IRA as your emergency fund or for home or education expenses in the next five years, be sure to keep the Roth IRA invested somewhere save and accessible like a money market account at a bank or credit union until you have enough savings outside the IRA to cover those short-term needs. At that point, you can then invest the Roth IRA money more aggressively for long term goals like retirement.)
Now, you may be wondering if it's really a good idea to be able to use retirement savings for these other purposes. Easy access can indeed be a problem if the "emergency" turns out to be a new big screen tv. However, you have to fill out a form every time you make a withdrawal from an IRA and that extra step tends to discourage people from spending it on frivolous things. Buying a home can also be a great investment for retirement, especially if it means having your mortgage paid off by the time you retire so you have one less expense to worry about.
Does this mean you should always reduce your 401(k) contributions to contribute to a Roth IRA? Not necessarily. First of all, if your company offers a match, it's pretty hard to beat getting an instant return of 50 or 100% on your money so make sure you're not leaving any of that money on the table. If you have a traditional 401(k), you also have to weigh the benefits of making pre-tax contributions against these Roth IRA advantages.
Finally, if you're going to reduce your 401(k) contributions, make sure you have the discipline to actually put that extra income in the Roth IRA and not spend it on something you don't need. Funding the IRA with automatic deductions from your checking account might be a good way to do that. After all, the only thing worse than not having emergency funds and being on track for retirement is not having emergency funds and not being on track for retirement.
Are you looking for an unbiased answer to your own financial question? Once a week, we’ll be responding on this blog to questions from our Financial Helpline or posted on our Twitter or Facebook site.
Liz Davidson is the founder and CEO of Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.
