A client recently asked me how to think about whether or not to contribute to a 401k plan that doesn’t offer a match, and while there are always nuances to decisions like this, there are some general things to consider for anyone in a similar situation. The decision comes down to a few factors:
- Do you want to save more than the annual IRA contribution limits ($6,000 in 2021 unless you’re age 50 or older, then it’s $7,000)?
- Is reducing your taxable income an important factor?
- Will you save for the future otherwise?
Let’s break each of these factors down.
Do you want to save more than the IRA limits?
As a general rule, IRAs offer more flexibility than 401k plans, so if you’re not able or willing to save more than the annual limit there, it typically makes sense to prioritize IRA savings, particularly if you’re looking at a Roth IRA. (if you make too much to contribute to a Roth IRA, here’s how to do a backdoor contribution and get around the income limits)
If you’d like to save more than that, it might still make sense to put the annual IRA limit in an IRA due to the inherent flexibility of IRAs versus 401ks (for example, IRAs can be tapped for first-time home purchase and education expenses without penalty, with Roth IRAs adding the extra benefit of your contributions being available for withdrawal at any time without tax or penalty), then contributing to your 401k beyond that.
How Do You Do a Backdoor Roth IRA?
How to fund a Roth IRA even if you make too much money.
The Health Savings Account exception
If you’re eligible to contribute to an HSA, then I’d actually suggest prioritizing putting the maximum in that account before contributing to your 401k or IRA. I get into that more in this post.
Why You Should Put the Max in Your HSA Before Putting More in Your 401(k)
It’s for more than just today’s out of pocket expenses.
Is reducing your taxable income an important factor?
Anyone can contribute to a traditional IRA (aka the one where you can usually deduct what you put in from your taxes) as long as they have earned income, but when you have a workplace retirement plan like a 401k available, even when there’s no match, the IRS says that you can only deduct your IRA contributions if your income falls below a certain limit*.
So if reducing your taxable income this year is the most important factor to you, you may decide to use the 401k as your savings vehicle unless your income is below the annual limits to deduct traditional IRA contributions.
* 2021 income limits are $66k — $76k for single filers, $105k to $125k for married filing joint and $198k to $208k when one spouse is covered but the other isn’t.
Will you save for the future otherwise?
Besides having a match, the other big argument in favor of saving in a 401k is that it’s as easy as it gets — once you set the amount you’d like to contribute from your paycheck, your employer takes care of the rest and you don’t to take any action unless or until you wish to change your contributions or rebalance your investments (which may not even be necessary if you’re using an asset allocation fund like a Target Date Fund — not to get jargon-y, but those are the funds where you basically pick one and the mutual fund manager takes care of making sure it’s properly diversified and rebalanced according to the year you chose).
Bigger picture, the end goal is to save for the future, so choose the path of least resistance.
If setting up an IRA and making sure you contribute according to your budget and lifestyle is likely to be something you might procrastinate (no shame! But be honest about your habits and blocks with money right now), then the 401k is likely to be the better choice for the simple fact that you’ll actually be saving for the future in a tax-advantaged way rather than beating yourself up over putting off starting that IRA.
Fees are important too
I feel like I have to address this aspect mostly because my fellow financial planners will be all over me if I don’t, but also it’s important — when you’re investing for the future like you do in 401k and IRA accounts, fees are the one thing you can control and they can make a significant difference in your investing outcome over time. If all other factors are equal and you just want to save for the future, it’s worth checking the fees that are charged by the investment options you’d likely choose in your 401k.
The bigger the company you work for, the more likely it is that you’ll find investment options with fees lower than any you’d find in an equivalent investment option at a retail brokerage, even Fidelity, Schwab or Vanguard, but if your company is pretty small and therefore it’s likely the 401k plan is pretty small, you’ll probably find better fees using index funds or other passively managed funds outside.
If you’re ambivalent about all the other differences between using an IRA versus a 401k, go with the option that offers the lower investing fees.
If choosing individual stocks is important to you, go with an IRA
This is not an article about investing, so I won’t go into the pros and cons of investing in individual stocks versus index funds or other mutual funds, but if you’re wanting to invest in individual companies, ETFs or other investment options outside of what your 401k plan offers, then starting with an IRA is the obvious choice.
I’ll just say this: picking stocks is inherently riskier than mutual funds, especially index funds, so if you’re thinking of going that route, know that the risk of short-term loss and sometimes even total loss increases with individual stocks, so just be sure you know what you’re doing.
Best case scenario prioritization of savings
When you have a 401k available but no match, and all other factors being weighed make sense, the most flexible and most tax-advantaged way to prioritize your savings is as follows:
1. Contribute the maximum to your HSA, if eligible
2. Contribute the maximum to a Roth IRA
3. If you wish to save more, then fund the 401k
What did I miss?
I work hard to make sure the personal finance guidance I offer is as approachable as possible, but sometimes it’s impossible to avoid using some concepts or phrases that require a bit more advanced knowledge of finances. If you’ve made it to this point and you’re not quite sure what something really means above, please feel free to comment or send me a note through my website for clarification. My bigger life mission is to make financial planning expertise available to everyone, regardless of income, education or ability to pay, so please let me know how I can help.
Disclaimer: The content of this post is for informational purposes and is intended to be educational only. It does not cover every possible nuance and is general in nature, and should not be relied upon as individual tax or investment advice. For a personalized evaluation of whether this makes sense to you or how to perform the transaction correctly, it’s best to work with a paid professional who can guide you within your personal circumstances.
For more about the author, please visit www.financialblisscoach.com