Video: Should you contribute to your 401(k) if your employer doesn’t match contributions?

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Got a video Q&A for you today.

Farrell from San Diego asks: “If my employer doesn’t match 401(k) contributions, should I still contribute to it? Is a Roth IRA a better option?”

In essence, he is asking, “What should I do with my investment money?”

Here are the basic points (more details in the video):

  • There is something I call the Ladder of Investing, which dictates where your investing dollars should go
  • First, contribute the max towards any 401(k) that’s matched. This is free money so do not pass this up.
  • Second, contribute the max to your Roth IRA (in 2012, the maximum is $5,000) . I explain why in my book.
  • Third, go back to your 401(k) and contribute as much as you can. If you max that out at $17,000 in 2012…
  • Fourth, open up a taxable investing account (basically, a normal, non-Roth, non-401(k) investing account) and invest there. There is no limit to how much you can contribute here, but if you’re earning enough to be able to invest over $20,000/year, odds are you’ll expect a high standard of living later in life, so invest aggressively.
  • Fifth, at this point, if you still have money to invest, you’ve earned yourself a little fun. Consider alternative investments — investing in yourself, angel investing, sparingly picking individual stocks, or even large-scale bets on delusional people’s ideas of when they’ll get married (ahem Indian women), like I do. These alternative investments should represent a small percentage of your total investing outlay — I like around 10% if you’ve maxed everything else out.

Check the video for more, including my specific recommendations for Farrell.

By the way, it’s easy to get intimidated by all of this. But the Ladder of Investing is a step-by-step guide to determine where your investing money should go. Once you set this up once and automate it, your money will flow where it needs to go for years. This is how people can earn millions of dollars over their lifetime by “setting it and forgetting it.”

If you’re curious about the automation portion of this…

Sign up for my free Insider’s Kit to get information on how to automate your finances!

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29 Comments

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  1. Where does a nondeductible contribution to a traditional IRA fit in your ordering? That can be rolled over to a Roth IRA.

  2. Wouldn’t it be very likely that anyone who makes it past step 4 would also be earning over the income limit for the roth IRA?

    Sure, there is the traditional IRA but it loses the tax deductability above a certain income as well. It still provides a tax benefit in that IRA holdings aren’t subject to taxes on dividends or realized profits but having to pay income tax on the deposits makes it less enticing.

    Honestly, I would imagine this would apply to many readers since with some careful negotiation and job searching, the $105k income where the Roth starts tapering down contributions (or $120k where they are forbidden) is within reach.

    • Very astute, yes. You have to skip the Roth option. Unless you own a small business, there aren’t too many great options for high earners besides ordinary taxable accounts.

      But that is still better than letting long-term money sit in a savings account.

    • Have you heard of a back door Roth IRA? There is no limit on income using this method..

    • You don’t necessarily have to skip the IRA option. Contribute to a Traditional IRA and then convert it (“recharacterize”) to a Roth IRA.

      Taxes are due on your gains, not your contribution. So if you contribute $5000 to a Traditional IRA, then convert it to a Roth, you’ve bypassed the income limit.

      You won’t be able to deduct this on your taxes, but you couldn’t do that anyway with a Roth IRA. I’ve done this a couple times and it works as advertised.

      There are more details than that, but that’s the gist of it. Please use this as an initial conversation with your accountant. Everyone’s situation is different. YMMV.

  3. How do we submit questions for “Ask Ramit”?

  4. I feel the Ladder would operate differently with something like a Vested 401k.

    My company, for example, takes 4 years I believe to reach a 100% vested match (25, 50, 75% over the years).

    25% of 5% of my income is paltry. 1.25% to be exact. Unless you’re planning on staying for years at this company (I sure hope to hell I don’t) it’s not the best bargain.

    Just thought I’d toss out those nuggets because I don’t believe vesting is talked about in the IWT book… though I’d have to check it when I get home to be sure.

    • Same here. My company documents say that the company contributions do not 100% vest until I complete 5 full years of employment at the company. I guess my 401k contributions are still tax-deductible though so there is still some benefit. I am curious as to how the ladder would be affected here.

    • Even if the 25% of your 5% is paltry it’s still free money. What happens if you end up at this company for 5 years? If you’re contributing money to retirement you might as well take the free money.

    • Still a no brainer IMO to contribute up to your employer’s match. You are not hurting yourself at all by doing this. Your AGI is still reduced and the employer vested/non vested issue has no impact on your W2 income. That way if you do end up staying at your company for 3 or 5 years, you’ll have that money. Make sense?

  5. Can I have the free money you don’t want then?

  6. Our retirement savings plan is quite similar; but my wife stays home so thanks to a spousal Roth IRA, we pretty well max out after step two (saving about $18K/ year). We then skip to step 5 and buy lottery tickets, okay, so we don’t do that, but we do have a few individual stocks with small balances.

    Steps 1-3 in your ladder mirror Dave Ramsey’s baby Step 4; solid advice.

  7. Have to say, these Ask Ramit videos are quite cool. Good way to get a quick Ramit-fix in the middle of the day.

    You should put a list of them on the site somewhere. Lifehacker seems to get them before posted here.

  8. My only beef with your strategy relates to my (and likely others’) 401k options. I work at a smaller Fortune 500 so I would assume my options are reasonably “normal”. I have the following options: JPMorgan Stable Asset Income, PIMCO Total Return, Dodge & Cox Balanced, Dodge & Cox Stock, JP Morgan US Equity, BlackRock Equity, Columbia Marisco Focused, Nuveen Winslow Large Cap, Wells Fargo Special Small Cap Value, TIAA-CREF Insti Small Cap Blend, Times Square Small Cap Growth, American Funds New Perspective, American Funds EuroPacific Growth, and our company stock. The expense ratios range from .2 – 1.2 with most either in the middle or near the top of that range and 2 at the bottom. (company stock has no expense ratio) Anything over 0.5 is ridiculous to me and I would have a very hard time buying based on historical figures I’ve seen.

    I hate all of these funds. I’m young, “living the dream” on a small % of my paychecks, and banking enough to significantly consider your third and fourth options.

    I agree that the tax deferring growth is relatively significant (if considering equal growth funds) and if/when I leave the company and roll the money into an IRA, I can manage more freely. However, in my opinion, these are such loser funds that I’ve bypassed the 401k after company matching, pay the taxes, and go straight to step 4. I miss out on the tax deferral but not complete tax deduction and I see greater returns with my personal stock/fund choices (by holding for greater than 1 year to enjoy long-term gains) that so-far, the decision has been a good one.

    Does my company have the lamest 401k options or am I missing something here? (like possibly the time I have/get to spend actively looking at funds and stocks or just my overall assessment of the available funds)

    • Your 401(k) options suck. Talk to HR. Raise a big fuss. It will be worth tens of thousands to you and it’s worth it. Unfortunately, few people understand how this works, so they go along with the default options.

    • Another question:
      There is a Roth 401k option. What’s your opinion on them? The company still matches the same amount I believe. Is this technically like getting a higher match as I never have to pay taxes on the company match ever?

    • The 401k options at my company suck too. But one thing that is worth considering, and that maybe would’ve been good for Ramit to add to his video, is that after you leave a job, you can take all that you contributed to and earned from that 401k and roll it over into your traditional IRA with no fees or penalties. Then within your traditional IRA, you will likely be able to invest in anything you want to invest in (if not, you need to open an IRA elsewhere and drop your current one). And at some point in the future, whenever it is best for you (meaning, when you can afford to take the tax hit), you can convert/recharacterize the money in your IRA over to your Roth (which also should allow you to invest in anything).

      Given that these days, people switch jobs MUCH more often than in the past, this is something to keep in mind.

    • Also, my company doesn’t do any matching for 401k contributions, but I still contribute the maximum 15% from each paycheck. I think of it as basically quadrupling the $5,000 IRA limit for me. I will leave the company someday within the next few years, and all that money will go over to my traditional IRA, and then possibly my Roth. And in the meantime, I’m still able to contribue $5k to my Roth while I’m at this job. I get some tax savings now by contributing to the 401k (income AND payroll tax savings — don’t forget about payroll taxes), and some tax savings later by contributing to the Roth. Perhaps good to do both, since we can’t predict with certainty what our future individual or national tax rates will be compared to what they are now. And whenever you can manage it down the road, between now and retirement, recharacterize to Roth.

  9. Some additional things to consider:

    An Emergency Fund – just how big do you want this? 3 or 6 months of expenses?

    Student Loans – pay the minimum/put more money towards it? I say the minimum because my interest rate is 5%, not to mention Time Value of Money with my savings added with tax benefits from a ROTH IRA/IRA or 401K.

    The match at my company isn’t a guarantee. Its based on profitability and we find out 2-3 months into the year. Not to mention its normally 20% on the dollar unlimited. I wish it was 100% or even 50% on the dollar up to a certain amount which would allow me a little more flexibility. Also, I’m fortunate to have a Roth 401k. :)

    Lastly, I try and save for big expenses (car repair, vacation, etc), and make sure I spend some of my money investing in myself!

  10. Emergency fund should depend on how stable your job is, own/rent, and family? IMO, if you have a stable job, single and rent, you could have 3 months EF. If you have a family, unstable job, own, then I would definitely recommend closer to a year. But every situation is unique :)

    I have a couple articles on my site about emergency fund and student loan/car loan debt. :)

  11. Ramit, would you recommend using the Roth 401k option if its available from your employer?

  12. How would the Ladder change if someone was planning on retiring early (say, at 50)? If the 401k is maxed, one wouldn’t be able to touch much of that money until 59 1/2 or whenever retirement age happens to be, decades from now. Or are there intricacies I don’t understand?

  13. I understand that this makes the most sense on paper. Times have changed, and most of us are responsible for our retirement now that pension plans are a thing of the past.

    However, I don’t think that this ladder makes since for everyone. If you have the ability to make it all the way through step 5, then sure. But, if you’re only able to get through step two, should every dollar you save really be going back into your 401(k)? Most 401(k)s are ridiculously expensive, and the investment options aren’t that great.

    Plus, some of the money you save has to be for shorter term goals (i.e. 5-10 years out). Throwing everything into retirement accounts may make sense mathematically if life goes according to plan for the next 40-50 years, but that rarely happens. You have kids, you lose your job, you have to pay for a wedding, etc. Or, you may just want to take a really great vacation at some point before you turn 59 1/2.

    IMO, you need a better balance between retirement savings and “before 59 1/2″ savings. If you can’t get past step 2, every dollar you invest can’t be 30-40 year money.

    • I completely agree which is another advantage of the ROTH IRA. If you find yourself in a jam and need some cash, you can borrow your contributions (no interest) at any time. You’ve already paid taxes so that money is yours free-and-clear.

      It should be noted that this should only be in absolute emergency. If you just want to go on some frivolous 1-week vacation, you should read more of Ramit’s stuff about earning side-income for such purposes. If you are not earning enough or prioritizing saving to get past step 2 (especially if you are past your mid-30′s) while going on the occasional vacation to refuel your batteries, you are very likely to be disappointed with your retirement lifestyle or the age at which you can retire. However, there are always the exceptions. For example, a doctor working in rotations can often delay their saving while their salary may be less by knowing that they are months away from comfy 6-figure salaries that will more than make-up for lost time in the savings department. This analogy can stretch well past the medical profession as well (i.e. entrepreneurs, MBA/PhD students, etc.)

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  15. Where does a non-deductible contribution to a traditional IRA fit in your ordering? That can be rolled over to a Roth IRA. Wouldn’t it be very likely that any one who makes it past step 4 would also be earning over the income limit for the roth IRA?