Should You Invest in a Bad 401(k) or 403(b)?

by Michael on Mar 20, 2013 · 5 comments

Photo of a Golden Nest Egg

I’ve been fortunate. Over the years, my employers have offered excellent retirement plans. But for many, that’s not the case.

If your 401(k) or 403(b) plan stinks — due to high fees, lack of appropriate investment options, or both — what should you do?

Should you still contribute? Or should you just fund an IRA and then move on to investing in a taxable account? Today I want to take a closer look at the options and offer some suggestions.

For starters, your retirement plan at work offers two main advantages:

  1. additional tax-advantaged investment space, and
  2. the possibility of matching contributions.

Currently, IRA contribution limits stand at $5,500/year, whereas 401(k) and 403(b) contribution limits are $17,500/year. So your limits at work are more than 3x higher. That’s a pretty nice option to have.

Of course, you can do both. So… Ignoring catchup contributions, this gives you the ability to stash a combined total of up to $23k/year in tax-advantaged accounts.

As for employer matches, many plans will match 50%-100% of your contributions up to a certain level. This is free money, and you should almost always take it.

In very general terms, when thinking about long-term (retirement) savings, I would prioritize things like this:

  • Fund your retirement plan at work up to your employer’s match
  • Max out your IRA (traditional or Roth, depending on your circumstances)
  • Go back to funding the employer plan up to the limit unless it’s truly horrid
  • If you’re still looking to invest, continue to do so in a taxable account

So… Once you’ve captured the matching funds, I would lean toward switching to an IRA as this gives you absolute control over your money. From there, I would likely switch back to the employer plan up to the max due to the tax benefits.

As for what constitutes a “truly horrid” plan, that depends on a number of factors (tax brackets, type of investments held, etc.) — but I would likely tolerate at least 0.50%-0.75% in added costs in exchange for the tax benefits.

If the investment choices are limited, you can always settle on the “least bad” and then balance things out in other accounts. Remember, when allocating your portfolio, you should look at the whole pot of money vs. trying to hit the proper allocation within each individual account.

As for the traditional vs. Roth debate, please see my earlier discussion of tax diversification. The benefits of tax diversification apply to both you work-related retirement plan and your IRA(s).

Note: If you’re covered by a retirement plan at work, your ability to deduct traditional IRA contributions phases out as your income increases. This changes the equation. But you can always work around the Roth IRA income limits.

Another consideration: If you ever change employers, you can roll your retirement plan into an IRA and extricate yourself from whatever negatives you’ve been dealing with. Thus, you may not be stuck with those high fees or limited choices for life.

Just keep in mind… If you’re planning on retiring between ages 55 and 59.5, it’s better to have your money in a 401(k) or 403(b) than an IRA because you can take distributions without incurring an early withdrawal. With an IRA, you have to wait until 59.5 (or jump through other hoops) to avoid the penalty.

Note: Just so you’re aware, much of the discussion above applies equally well to 457(b) plans. However, these rarely offer matching contributions so I’d be less likely to put them at the top of the list.

1 Kurt @ Money Counselor March 20, 2013 at 12:12 pm

Good advice I think. Capturing the match in an employer-sponsored plan is a must, as you note. Free money! I think all employer-sponsored plans offer a money market option, so you can always do that if the other options are really poor. Even earning next to nothing on the money market is acceptable given the tax benefits and match benefits.

2 Ben March 22, 2013 at 9:51 am

You neglected to mention that traditional IRA contributions’ deductability phases out with income if you are eligible for an employer-sponsored retirement plan. For single people, I believe the phase-out is only in the 60s or 70s of (M?)AGI; I was in the phase-out period in 2011 and had to limit my IRA contribution because of this. So sometimes it’s not an either-or decision, you HAVE to contribute to the 401(k) or nothing at all.

Some other options, none of which are that great:
– by contributing a whole lot to a 401(k) you might be able to lower your AGI enough that you become eligible to also make IRA contributions.
– get self-employment income through a side job and start a solo 401(k). As long as you make enough self-employment income, you can contribute up to the same limit as a work 401(k) (but the max applies to both accounts in total), plus you can make up to a 20% contribution of your self employment profit. The benefit is you can open a solo 401(k) through any provider you want like Vanguard or Fidelity.
– Switch jobs frequently. Once you leave you can roll the 401(k) over into another plan with better options. If you’re only in the bad 401(k) plan for a couple years you don’t lose that much to expenses. Of course, if the job has a match that requires a long vesting period, this won’t work.

That last one makes me wonder how long it will take for employers to realize that a bad 401(k) is DISCOURAGING their employees from staying with the company??

3 Michael March 22, 2013 at 10:19 am

Ben: Excellent point. I can’t believe I overlooked that. I have added a not with a couple of relevant links. Importantly, while your ability to deduct phases out, you can still contribute to a Roth IRA.

This is true even if you’re technically over the income limit (backdoor Roth) and it’s worth considering, especially if you have a traditional 401(k) or 403(b) at work — the Roth will give you some tax diversification.

Thanks for your thoughtful comment.

4 Ben March 22, 2013 at 4:45 pm

Yes absolutely. That’s what I ended up doing that year: contributing near the max to the traditional IRA and put the rest in a Roth. I was beginning self employment in 2012 so I was trying to reduce my tax liability as much as possible for 2011 to minimize my estimated payments that would guarantee no penalty.

5 Martin April 6, 2013 at 10:21 pm

This is a great review. I was dealing with this exact thing recently. Our 401k somewhat sticks – poor choices and high fees (not as good mutual funds as I would wish, their expense ratio is around 2, and we only have a few to choose from) but I am taking it because of employer’s match. The rest of my cash goes to ROTH and IRA.

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