Five Situations When You Should Not Contribute To A 401k

by Neal Frankle, CFP ®

Normally it’s brilliant to take advantage of and make contributions to your 401k.  When you do, you get an immediate tax break (unless it’s a Roth 401k) and you build up a nice retirement nest egg for yourself to boot.  Not bad.  But there are 3 situations where making contributions to a 401k is a bad idea.  Let’s take a closer look.

When Not To Contribute to a 401k

There are at least five situations when you should not invest in a 401k retirement plan.

1. Debt

First, if you have high cost debt (like credit card debt), you should pay that debt off first (as long as you’ve taken steps to cut your spending and eliminate this problem once and for all). The reason for this is because credit card debt usually costs you much more than you can earn on your 401k. Even if you get a match from your employer, that match is typically limited to a small amount of your total contributions for the year.

If you have credit card debt and your employer matches the first $2000 you contribute to the 401k plan. You might decide to first contribute $2000 and then cut off your 401k payments and direct all your resources to getting rid of that rotten debt.

2. No life insurance.contribute to 401k

If you need life insurance and can’t afford it, you should buy the right insurance and the right amount before contributing to your 401k.  That’s because you really never know when your number is up.  If other people rely on you financially, they come first.

Neal’s Note – If you do contribute to your plan, are you investing wisely

3. Higher tax bracket.

If you are sure you are going to be in a much higher tax bracket when you retire than while you are making contributions, you should not build a 401k. That’s because you’ll get the tax break for making the contributions when your tax bracket is low. But you’ll incur taxes when you take the money out during retirement – when your taxes are much higher.

On the face of it, this is true but be careful.  It’s hard to know what your tax bracket is going to be in the future.  Unless you are certain of this, don’t use the tax bracket issue as an excuse to justify not contributing to the 401k.

4. Shaky Employer

If you fear that there is employer fraud or that the company is on its way out, you should not invest further in your 401k plan. Even though companies go bankrupt all the time and 401k plan contributions are generally safeguarded, I suggest you pause.

In most cases, your money is safe regardless of what happens to the firm you work for. But sometimes the firm itself acts as custodian. If that is the case, the last thing you’d want to do is put more of your money into the hands of a firm in financial trouble.

5. Investment Options

The last thing to think about is the availability of investment options. If your employer only allows you to invest in company stock with 401k plan money, I would not contribute a dime. And if your employer has an extremely limited menu of options, I’d probably limit my contributions to the matching level and stop there.

In fairness, there really is one more reason why you shouldn’t make use of your 401k and that is if you have higher paying alternatives outside the plan. But be mindful of the risk and security. The only investment you can’t make inside a 401k that you can make outside the plan is real estate.

But it’s tough to buy real estate with the monthly contributions you would make to a 401k plan. You need a larger lump sum for a down payment to get the ball rolling. For most of us, real estate is not a real competitor for 401k contributions.

Bottom line? Read this list. See which conditions most closely describe you. Then decide if you should contribute to a 401k or not.

Are you participating in a 401k plan at work? Why or why not? What are your frustrations and fears? What benefits do you enjoy that I haven’t described above?


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{ 9 comments… read them below or add one }

Mike January 20, 2013 at 7:45 AM

The advice that is often given about “if you are going to be in a higher tax bracket in retirement” is somewhat misleading. When you take money out in retirement you will be paying your effective tax rate on those withdrawals. The money you contribute today is avoiding being taxed at your marginal rate. Your marginal rate is considerably higher than your effective rate (unless you are making a large amount over the highest bracket).

Regardless of future tax rates almost all of us will save tax dollars by using the 401k. The other reasons not to are valid but the “higher tax bracket” is a common refrain that is misunderstood.


Neal Frankle January 20, 2013 at 9:51 AM

Mike. I guess what you are saying is that “higher tax bracket” really means “marginal higher tax bracket“. Thanks for the clarification. I agree.

I do not believe it’s a misunderstanding but rather a lack of clarification.


JoeTaxpayer January 14, 2013 at 1:58 PM

A few points to add. The fees in the 401(k) are the larger factor for me. An ultra low cost (say <10basis points, 0.10%) S&P fund can be a great portion of one's retirement picture. An option with 1%+ annual expenses should be avoided completely, except for the match.

It's the rarest of cases where one should not deposit to get a 50 or 100% match. I understand paying off 18%+ credit cards should be high on the list, but I'd eat rice and beans for dinner 3 times a week to fund that matched portion as well.

Last, Emily, I have one word for you, Sec 72(t). Pre-59-1/2, you are still permitted to take withdrawals with no penalty. This provision requires you take a “series of substantially equal periodic payments (SOSEPP)” from your IRA for 5 years or until age 59-1/2, which ever is later. On another note, if you retire well before you are able to collect social security, using partial Roth conversions each year is a great way to level your lifetime tax burden, and avoid the runaway RMDs as you get older.


Sanjay Parekh January 14, 2013 at 4:39 AM

Forgot to turn on the notification!


Sanjay Parekh January 14, 2013 at 4:39 AM

Is there any tax deferred alternative available if the employer offers a lousy 401k plan? I do a better job than almost all the funds in my employers 401k plan. But as I understand since my employer offers the plan I don’t have a choice to contribute to say an IRA. I hope I am wrong!


Neal Frankle January 14, 2013 at 9:07 AM

It depends on your own situation and how much you earn. I strongly suggest you speak to your tax advisor but if your income exceeds a certain amount, you can contribute to an IRA but not deduct it. That being the case, a ROTH IRA may be the way to go.


Neal January 9, 2013 at 7:57 AM


I completely agree. Thanks. This is smart planning. Another good reminder that you have to tailor your financial decisions to your own particular situation. Great stuff.


Emily January 9, 2013 at 7:46 AM

Another reason not to contribute in a 401k is if you are planning to retire super-early, like we are soon, and want to be able to access money without getting slapped with a 10% penalty or having to go through red trip.

Also, in our early 40’s, we have plenty in our retirement funds, enough to just let sit and grow until we can legally access them without penalty. So we are focusing our investments in non-retirement mutual funds.


Shaun February 4, 2013 at 6:11 PM

Or you could retire move to a no tax state for a bit and roll the 401 into a roth avoiding state taxes and the 10 percent penalty and giving you access to the money now if you wanted it all while keeping it in an account that grows tax free that you have control over.


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