Should I max out my 401k first before I invest in index funds?

I want to save for retirement and want to get the highest return when I turn 65. I’m 26 now. I have some money in an index fund already and thinking about adding more in, but should I just increase my 401k contribution percentage instead?

Yes. The tax deferral will almost certain be more important than the gain, plus most 401ks will have an index fund option.

But OTOH, if the plan does not have an index fund option, the extra volatility plus extra fees might total up to a 2% difference over the index fund which would more than make up for the taxes. But it might.

Then again if you will be able to roll over your 401K in the medium-term future to an IRA, it might be worth it to max out your 401K even if there are no low-fee funds available, and then roll it over to a cheap IRA with lots of index options like Vanguard as soon as possible.

If you have not yet maxed out to the point where your employer will match, the answer is a no-brainer to increase 401K contributions. If the decision is just between increasing non-matched 401K and other, it depends on a few other variables.

My company doesn’t offer a 401k. I was under the impression that low-cost index funds were pretty much a default option in 401k plans. Is this not the case?

I’ve heard that you should first contribute enough to the 401(k) to get the maximum employer match, then invest in a Roth IRA as much as possible, and then, if you’ve maxed out Roth IRA contributions, to contribute more to the 401(k) until you reach its maximum.

Are you *only *saving for retirement, and not for anything like a house or a future child’s education?

Then maxing the 401-K would probably be better.

Especially if the OP can go with a Roth 401(k), where there’s no immediate tax benefit but the long-term tax benefit is tremendous especially given the long time-frame.

Definitely make sure you’re putting enough into your 401(k) to get the maximum company matching, otherwise you’re leaving free money on the table.

My next priorities would be a combination of paying down debt, saving for short-term goals (e.g. house down payment, car purchase, saving for grad school if appropriate), then increasing the retirement savings one way or the other.

I would definitely suggest choosing a Roth vs regular vehicle wherever you have a choice, because at your age, you’ve got 40ish years for that to grow. Even if you’re at a lower tax bracket later on, you’d still be paying tax on what you take out if you have the traditional form. So if you do NOT have a Roth 401(k) at work, put aside your 6% or whatever for the matching, then fully fund a Roth IRA, then put anything left after that into the 401(k).

It varies pretty widely. There are often index funds, but they might not be as low cost as you’d like.

For example, the lowest cost fund in my 401k is an S&P500 index fund with an expense ratio of 0.4%. You can get a comparable fund from Vanguard for only 0.17% at this time, so I’m paying more than twice as much as I would if I were choosing the fund. My 401k also has quite a few funds with loads and much higher expense ratios.

Lots of advice at FIRE.

I’m mainly saving for retirement at this point. I’m single, no kids, and just want to set up my basic finances before thinking about buying a house. From the responses so far, I’m still torn.

My company’s 401k fund selection is pretty crappy (no index funds) with high expense ratios. I am contributing because of the deferred tax benefit and the employer match. The index fund I’m thinking about adding to is in fact from Vanguard (ridiculously low expense ratio); hence the dilemma.

I’ve gone beyond the employer match percentage, and I actually don’t know how much the tax deferral is benefiting me. The money taken out for the 401k is not that significant as to move me from one tax bracket to another. Any other reasons to max out the 401k?

Regarding Roth versus traditional, I’m not convinced one is better than the other necessarily, as it seems to depend on the difference between my tax bracket now and my tax bracket when I withdraw. I don’t think my income when I retire will be that much higher than what I make now, but who knows.

Run both scenarios through an Excel spreadsheet.

for 2011, deposit X pre-tax dollars into your 401K. Add in your employer matching contribution Y, whatever that works out to be. Identify whatever the expected gross annual return is for the fund you choose, and subtract the expense ratio to see your net annual rate of return. Raise net annual return to the 39th power (you’ll retire in 39 years), and multiply by the initial investment value (X+Y). Example: $1000 from you, $500 employer-match, 8% annual return, 1.5% expense ratio. Final value = $1500 * (1.08-0.015)^39 = $17,487.

for 2011, take X pre-tax dollars, subtract Z percent (where Z is your marginal income tax rate), and invest the remainder in an index fund. Again, ID an expected annual return and an expense ratio (typically around 0.1% for an index fund). repeat the math for #1 to determine the final value of your investment.

You can also run a split-case: put enough in your 401K to maximize your employer-match, and then take any excess and invest it in an after-tax index fund.

The challenge of course is to identify realistic rates of return in any case. The stock market has done pretty well over the past 100 years, which would lead you to believe index funds can return something around 9% over the long haul - but many believe the future is more bleak than the past, so who knows? at the least, doing this math in a spreadsheet will let you tweak the input values and see if there’s a huge difference (in which case the choice is obvious) or if there’s only a small difference (in which case uncertainty means the real outcome could go either way). If it’s a wash, then the smart choice depends on how you assess your self-control. If you have good self-discipline, then don’t put your money in the 401K; that way you’ll be able to access it without penalty in an emergency. If you are a spendthrift, then lock your money up in the 401K so it’ll be safe from your shopping compulsions for the next forty years.

P.S. You can determine your marginal tax rates by checking the formulas on the last page of this PDF file; example, if you’re single and your taxable income last year was $33,000, then your marginal tax rate was 15%.

Depending on how much you make, you could also take money after the employer match and deposit up to $5000 in an Individual IRA, so you can choose funds with the lowest expense ratios, or individual stocks. With a 401k available at work the tax deduction for an IRA goes down at lower limits but if your salary is low enough you can do both. IE see Can You Have a Traditional and a Roth IRA?, which seems to say that if you make <$56,000 as a single you can contribute a full $5k to an IRA.

Lots of good advice there!!

I did want to comment on the mention of emergency: one of the benefits of saving via a Roth IRA is that you can access your money, the deposits at least, without penalty. There are some restrictions, like it has to be there for 5 years before you can touch it (don’t quote me on that, I may have the time period wrong).

In the OP’s case, it sounds like he’s not happy with the choices offered in the current 401(k).

Ignoring what to do with other money, bear in mind that you most likely won’t be with that company forever. At that time, you can move that money into an IRA (and even roll it into another empoyer’s 401(k) if you like the choices there). So don’t let a currently-too-high expense ratio completely dissuade you from using the current options.

I’d do a traditional over the Roth. The growth of the extra dollars in now makes up for the taxes later - mathematically (depending on your assumptions) it tends to be a wash. And I don’t believe in paying tax today that I can put off paying until tomorrow.

But sometimes you are allowed the choice of the exact same contribution maximum to both a traditional and a Roth. The fact that Roth is post-tax means that even though the returns are generally the same after taxes, you are effectively giving more if you are maxing out the Roth because it is already post-tax dollars.

I think where they equalize is if you’re disciplined enough to put aside and invest what you’ve saved in taxes. Say you invest 10,000 pretax, your net income hit is only 7,000 after taxes (assuming overall a 30% rate including state and Fed). If you ALSO invest that 3,000, then that grows also.

The contribution max is, I think, the total of all your regular and Roth. So you could put 5,000 regular and 0 Roth, 2500 in each, or 0 regular and 5,000 Roth.

The comparison gets pretty complicated and requires a lot of assumptions, but I find it hard to find any realistic scenario in which, long-term, a regular investment is better than a Roth.

Say you put aside 5,000, and it grows at 5% per year. Your tax rate right now is 20% for simplicity. Your tax rate at retirement is also 20%. At the end of 40 years it has grown to 33,523,76.

If you have a Roth, that 33,523.76 is all yours. Yeah, you were down 1,000 at the start so your net improvement in cash is 32,523.76.

If you had a regular IRA, that 33,523.76 is taxed at 20%, so you only have 26,819.00. A difference of 5,704.75 (the tax is 6704.75, but you had 1,000 more to begin with.

If you invested that thousand dollars, it brings the totals closer together. I may have made errors in my spreadsheet, but putting that thousand aside and getting the same 5%, minus 20% each year, gives a net of 6577.65 over the same 20 years.
So if you put it aside and leave it alone, pretax puts you slightly ahead, all other things being equal. I’ve actually seen articles written by people more competent than I am, making much the same point.

Most people, I think, are not as disciplined as that. Certainly we take advantage of our current-year tax savings on our pretax dollars, we’ve got kids and an expensive housing habit, all of which require money to feed.

A nondeductible regular IRA is where (in my mind) things get to be too damn much trouble. You don’t get the immediate tax savings, you DO get the tax-deferred growth, and when you cash it out, you have to figure out the percentage that’s taxable and the percentage that isn’t. So if you have a thousand, that grew to 10,000 by retirement, and in year one you take out a thousand, 10% of that (or 100 dollars) is tax-free. The next year, depending on how much the balance grew in the following year, you have to figure out the 900 dollars pretax vs current balance, and how much is tax free THAT year.

A non-Roth IRA (either pre or post) is great if you’re pretty sure your tax bracket will be lower in retirement. With all the numbers above, think if your bracket is 15% when you quit working and it tilts the numbers differently.

That assumes that you can afford to max out both. Most people who meet Roth income requirements can’t.

i.e. if I can afford to save $13k from my salary each year, do I put $13k aside pretax and let the whole thing grow, or do I put $9k away ($13k-taxes) and let it grow.

I ran a whole semester running numbers. It depends on your assumptions, but if you assume a lower tax bracket in retirement - which most people will have - and can’t max out the contributions because you need the money to live - a traditional 401k can come out ahead. Its often a wash. A Roth makes sense if you are willing to bet that your taxable income in retirement will go up.

One other thing thst just occurred to me: with a Roth, you do not have to start taking your distributions at age 70 and a half. I believe your heirs may also have more flexibility in taking distributions as well, not sure of the details.

On the income limits: I don’t know if this loophole has been closed yet, but at least for the past couple of years: there’s an income restriction on contributing to the Roth IRA… but there is NOT a restriction on converting a regular IRA to a Roth.

So you could put your money into a regular one (most likely with posttax money), then immediately turn around and convert that to a Roth. Any income in the interim would have to be converted and you’d have to pay tax on THAT, but if you do it fast enough there wouldn’t be much income.

And right now the finance blogs are abuzz about UNDOING that conversion. With the stock market tanking, its been a bad thing.

I spent some time with a calculator and our balances and decided that it was likely to be a wash if we converted.