Should I Contribute to the Retirement Plan at Work? (Part 1)

In a recent post, I talked about how relying too heavily on your 401(k) as a retirement vehicle can lead to unintended tax consequences later in life. Well, another issue with 401(k) plans is that they tend to offer an extremely circumscribed universe of investment choices. In most cases, you’re limited to a menu of mutual funds – one of which might invest solely in the company’s own stock. For the “hands-on” trader/investor, this can feel like an advanced swimmer being told to swim in a kiddie pool, but even for the “hands-off” investor with little or no knowledge of how to invest, this situation is less than ideal. To be fair, the mutual funds in a 401(k) typically charge you less than those you could go and buy on your own, but you still might end up paying more than if you went with a “robo-advisor” who would construct a portfolio of low-cost ETFs for you. And the robo-advisor would even do the work for you of deciding what to invest in and how much, based on information you provide about yourself.

So, does this mean there’s no point in contributing some of your hard-earned money to the 401(k) or other retirement plan offered at your job? The short answer is “It depends”. But of course, that’s not very helpful, so this multi-part post will explore the long answer to the question, culminating with a simple, low-cost solution to help you manage any money you do choose to put inside a workplace retirement plan.

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Before we proceed, I should acknowledge that what some of you have at work might not be a 401(k). But if your workplace offers you a 403(b) (also known as a “tax-sheltered annuity” or “tax-deferred annuity”), or you work for a state, county, or city government that offers you a 457(b) (also known as a “deferred comp plan”), or you’re eligible to take part in the federal government’s TSP (“Thrift Savings Plan”), then this series of articles is just as much for you as it is for the 401(k) crowd.

And now, without further ado, let’s take a look at some scenarios in which it might make sense to put some of your money to work in your workplace retirement plan:

(1) The employer offers matching contributions

Free money! Now, if this is the only reason that makes it worth your while to contribute to the workplace plan (as opposed to somewhere else), you may want to limit your contributions to no more than what’s needed to max out the employer match. For example, suppose that your employer will match your contributions up to 3% of your annual salary, and that 3% of your annual salary comes out to $75 per paycheck. Now, let’s say you’re prepared to invest $600 per paycheck towards your future. That's great, but if you plunk that whole $600 into your workplace plan, you’ll still only get a match of $75. It therefore might make sense to contribute just $75 per paycheck to the plan and take that other $525 per paycheck that won’t get you anything extra from your employer and invest it elsewhere.

(2) The plan allows Roth contributions

The TSP as well as many 401(k), 403(b), and 457(b) plans allow you to make “Roth contributions” (also known as “Roth 401(k)”, “Roth TSP”, etc.). Roth contributions to these plans enjoy the same tax treatment as a Roth IRA: once 5 years have passed since your first Roth contribution and you’ve reached the age of 59½, the profits on your Roth contributions become tax-free. However, workplace plans that allow Roth contributions possess two major advantages over a Roth IRA. First, unlike a Roth IRA, you can’t make “too much” money to contribute to a Roth account inside your workplace retirement plan. (Sadly, I’ve met people who failed to take advantage of their workplace Roth account because they thought they made too much money to qualify.) So, if your income is too high to open a Roth IRA (or add money to an existing one), a Roth 401(k), etc., offers a workaround. Second, the amount you can contribute to a Roth 401(k), etc., is much higher than a Roth IRA. In 2018, you can contribute up to $5500 to a Roth IRA, plus an extra $1000 if you’re turning 50 this year or have already turned 50, but to a Roth 401(k), etc., you can contribute up to $18,500, plus an additional $6000 if you’re turning 50 this year or have already turned 50! So, when it comes to socking away money that can be tapped into tax-free after you turn 59½, there’s no contest. And to sweeten the deal even further, if your income isn’t “too high” to contribute to a Roth IRA, then you can still do so even if you’ve maxed out your Roth contributions at work! The limits for one don’t affect the limits for the other.

By the way, if your employer offers a match, then you’ll get those matching contributions regardless of whether your contributions are pretax, Roth, or a combination of the two. But be aware that those matching contributions will receive pretax treatment: excluded from your taxable income that year, but taxable when you withdraw them in the future.

Finally, a word of caution: Believe it or not, the money you accumulate on the Roth side of a workplace retirement plan will, after you turn 70½, be subject to RMDs (required minimum distributions)! Of course, the profits won't be taxed, but you still need to pull money out of the account in accordance with the government's timetable. Fortunately, there’s an easy fix: roll that Roth money over into a Roth IRA, and - poof! - no more RMDs!

(If you’re not sure if your workplace plan allows Roth contributions, consult the summary plan description, a document your employer is required to make available to you. Check your employer’s online benefits portal or ask your HR department about it.)

Note: These are not the only two scenarios in which it might be wise to contribute some money to your workplace retirement plan. But it's a lot of information to digest, so I figured I should break it down into bite-size pieces spread out over a few posts.

Links to other parts:
Part 2
Part 3
Part 4
Part 5