Thursday, August 07, 2008

Are 401 K Plans the Best Place for your Money?

Since the development of the first 401 K plan back in 1979, these retirement plans have been the first choice for investors. However, are they the best choice for your retirement money? Well, let’s take a look at the advantages of a 401 K plan.

I can really only think of three. First, you do receive an up-front tax break on your annual deposits. I think that this is one of the main reasons most investors invest into the 401 K plan and it is the tax break. However, is a tax break a good enough reason?

Second, and the only reason to invest into a 401 K plan, is the employer match. It never makes sense to pass on free money. If an employer is giving away money, it makes sense take advantage of it.

Third, and maybe a stretch, it is a convenient way to invest money. There is a great convenience factor of the money never making it into your checking account and going directly into your bank.

So, what are the downsides?

First, the high expenses associated with investing in a 401K plan. Expenses inside of these plans are higher than most people think. Unfortunately, they are not fully disclosed and hidden.

Second, and the biggest drawback with 401 K plans, is options. Most 401 K plans don’t have enough of the types of investments that really help you an investor to properly diversify.

So, what is the verdict? In most cases, I have always believed that you take advantage of the match that an employer is will to give for investing into the 401 K plan. That is a key advantage. Beyond the match, I don’t see a good enough reason for investing into a 401K plan. Once again, this is in most cases.

Most investors would still argue that the tax advantages make it worth it. I would argue that the lack of options in most 401 K plans is a much bigger disadvantage.

So, what would be the alternative?

Consider investing the maximum amount possible into a Roth IRA. A Roth IRA will not give you a tax advantage up-front. However, it potentially gives you an enormous tax advantage when you withdraw the money. All of the money that you earn is never taxed during the growth stage and never taxed when you take it out. This is a tax-free distribution. In my opinion and in most cases, that will be a much greater tax advantage than getting a small up-front tax deduction.

Plus, you have the flexibility and all of the options that are afforded to you in a regular IRA brokerage account. You would no longer be restricted with limited options.

What if you don’t meet the requirements to invest into a Roth IRA? Well if you are a couple and your adjusted gross income exceeds 160,000, you cannot make a contribution. Instead, you make an after-tax contribution into an IRA. Then in 2010, new regulations take effect that will remove those restrictions on the Roth. You then transfer the money from the IRA into the Roth.

The only downside to this strategy is that you might owe taxes on some of the money that you convert to the Roth. However, the Government is giving you more than 1 year to pay the taxes back.

This is an example of how to get the best of all worlds while investing for retirement.

This is one way to invest for retirement. The key before implementing any strategy is determining if it is right for you.