Today, guest author Jeff Cooper of Have Your Dollars Make Sense offers interesting views on alternatives to 401(k) accounts. I maximize my 401(k) with my investment strategy, but I enjoyed understanding Jeff’s ideas.
Thanks Jeff!-Jesse from The Best Interest
For most of us, a 401(k) is our main approach to saving for retirement. The concept is easy—stash away money now and use it later. But there are alternatives to 401(k) accounts…and for good reason!
Many people take pride in saying “I max out my 401(k)”, with the assumption they are taking the best possible route to retirement. But are they?
The two main objectives of investing are diversifying assets to lower risk while still maximizing returns. 401(k) accounts don’t check both of these boxes all of the time. They are a great tool for retirement planning but shouldn’t be your only tool.
So let’s look at alternatives to 401(k) accounts that will make your money work best for you and your retirement goals.
401(k): Why You Should Contribute
I’m not suggesting you completely ignore your 401(k). There are good reasons why you should be contributing. To name a few…
Many companies that offer 401(k) accounts will also match a percentage of an individual’s contribution. In the eyes of the employee, this is literally free money. There really is no reason not to take advantage of this benefit. Avoid any alternatives to 401(k)s that neglect this free money.
You should, however, be aware of how much your employer will match. Many employers cap the matching around 4-6% of your salary. After that, only your dollars will count towards your nest egg.
I also recommend looking into your company’s vesting schedule to understand when you’ll get partial- and full-ownership of the company matches.
Some companies will “clawback” their matching funds if you leave before a predetermined amount of time. You should, however, still be entitled to your full individual contributions. You’ll have to determine if you plan on being at your company long enough to take full advantage of their matching.
Maximize Pre-Tax Dollars
Another money-saving advantage of a 401(k) is that your money is invested before taxes are taken out. This means you’ll get more bang for your buck, and here’s why:
If you wait to invest your post-tax dollars, there’s less money available to invest. For example, let’s say Jesse loses $50 per month due to taxes. It might not seem like a big deal. Just $50 a month!
But that $50 deficit will add up over the years. $50/month * 30 years = $18,000!
On top of that, the power of compounding gains on those missed dollars could be a difference of tens of thousands of dollars by the time retirement rolls around. The example below shows how Jesse might miss out on $40,000+ in compounding returns.
Lower Taxable Income
Contributing pre-tax dollars to your 401(k) will also help to lower your taxable income. Few alternatives to 401(k) accounts can mimic this benefit.
Let’s say you have a salary of $100,000 per year.
If you contribute 8% of your salary, not only are you investing $8,000 of untaxed earnings but now Uncle Sam will only consider the remaining $92,000 to be taxable. It’s a rare win-win situation for the little guy when it comes to tax season.
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Alternatives to 401(k): Customize Your Investment Strategy
There are definitely advantages to contributing to a 401(k), and it’s easy to understand why it remains one of the most popular investing options. But it’s also important to take a step back to think about what you’re ultimately trying to accomplish.
Here are some alternative ways to invest in your financial future (both short- and long-term) that may be better suited for you and your retirement goals. Let’s step through these alternatives to 401(k) accounts one by one.
Assess Current Financial Obligations
Retirement should be one of your top financial priorities once you enter the workforce, but that doesn’t mean you need to throw every last penny towards it right away.
In the beginning, contribute what you can while still maintaining current financial responsibilities. Once you start to build up a solid financial foundation, you can begin to increase your contribution accordingly.
Another top priority is that emergency fund. Ideally, everyone should aim to have four to six months’ worth of expenses stashed away somewhere nice and safe. If you don’t have that money set aside, then putting less into the 401(k) and more into your savings may be more beneficial.
Debt is also a big factor to consider when determining your contribution. For as much as compounding gains can help you, compounding interest payments can be devastating. The interest rate on debt is typically guaranteed, but the rate on your investing gains often isn’t.
While you don’t need to wait until you are 100% debt-free before investing, you do need to be able to comfortably make all debt payments (and preferably extra) before amping up your 401(k) contributions.
Don’t Limit Yourself
Remember that diversity objective? Well, in my opinion, you can’t get a truly diversified portfolio in a 401(k).
Most companies provide a basket of 20-30 different mutual funds to choose from, and that’s all you get. Yes, by nature mutual funds will give you some degree of diversity. But you can’t reach the same levels that a traditional investment account can offer.
Plus, I wouldn’t want someone telling me what I can and can’t invest in. It’s my future! Alternatives to 401(k) accounts can open more doors.
And here’s a heads-up: mutual funds charge fees for managing your money—often called the expense ratio. Make sure to look for funds with low expense ratios. Index funds are typically the lowest.
Alternative Investments Can Potentially Offer Higher Returns
Buying individual stocks isn’t typically available through 401(k) accounts. But historically, stocks have much higher returns than bond-laden mutual funds. Plus, there are no management fees when you pick your own stocks! You buy them at a fixed price and that’s that.
Yes, there’s a higher risk involved with hand-picking stocks. But the objective here is to grow your money as much as possible. If your risk tolerance is low, then you may want to stick with mutual funds.
For those who are willing to roll the dice on alternatives to 401(k) funds, stocks are the way to go. Investing in stocks while still contributing to 401(k) mutual funds can both increase your returns and diversify your portfolio.
Investing isn’t limited to the stock market either. In today’s world, there are tons of different investment opportunities. Money can be invested in ways that weren’t always available to individual investors in the past. There are sites that let you invest in startups, cryptocurrency, online REITs, and the list goes on.
Each alternative to 401(k)s comes with a unique risk\reward profile. But again, it’s all about diversifying and maximizing those returns. If you’re younger and can afford to take risks, then the choice is yours.
401(k)s don’t typically provide the opportunity to make these kinds of higher risk, higher reward investments.
Use Alternatives to 401(k)s to Align Overall Retirement Goals
Most people just assume they’ll work until they’re 55, 60, or 65 years old and use the 4% Rule. But that’s not for everyone—I know I don’t plan on it!
If you’re looking forward to an early retirement like I am, you’ll need access to your money. This may be a problem if most of your investments went into your 401(k), as you can’t begin to make penalty-free withdrawals until the age of 59½. The money will be sitting right there, but you can’t touch it without getting slapped.
Having a well-diversified and accessible investment portfolio will allow you to retire when YOU decide you can.
401(k) accounts have their advantages and deserve a place in your retirement portfolio. They offer several tax benefits and might give you free money, making it a no-brainer to contribute to them right away.
But you shouldn’t overlook the other options out there. There are alternatives to 401(k) accounts that have lower fees and higher returns. The money saved from fees and gained from higher returns could potentially outweigh the taxes you might save. It’s a big balancing act.
But remember: whatever you decide to invest in, it’s bringing you closer to your retirement goals and financial freedom!
Thanks again to Jeff Cooper of Have Your Dollars Make Sense for today’s article.