Should You Contribute to a 401k or Not?

by Neal Frankle, CFP ®

If you are debating if you should contribute to your 401k or not , the answer is – “it depends”. Even if your 401k performance hasn’t been up to par lately, it doesn’t mean your retirement account is a bad deal for you. Still, I’ll admit there are pros and cons. Let’s review these two sides as objectively as possible.


Your 401k account acts as a protected, tax-deferred account structured to make your retirement a trip down Easy Street. Theoretically, the money grows faster than accounts outside your retirement account because you pay no taxes on the 401k as it grows. Add to this the fact that your employer might match a certain percentage of what you put in to your retirement account and you’ve got a pretty juicy opportunity.

Why You Would Contribute to Your 401k

I mentioned above that your 401k is protected. “Protected from what?” you might ask. The answer is, protected from you. My experience tells me that most people accumulate wealth in two places; retirement accounts and real estate. One of the major reasons that your wealth is likely to be accumulated around these two areas is because it’s so hard to spend the money put into these investments.

If you have money that is easily accessible it’s easy to spend. Alas….as a result, it gets spent. But real estate is difficult to pull money from – it takes time and costs money to get inside your property cookie jar. As a result, people tend to leave it alone as compared to money in the savings account.

Money in retirement accounts is also expensive to get your hands on. If you take money out of your retirement accounts there aren’t many ways to avoid taxes and penalties. So these two investments have walls around them that protect you from yourself. This is a huge advantage to contributing to your 401k.

I mentioned above that often employers provide a match for some of your contributions and this is a big plus too. If you deposit $100 into your 401k and your employer kicks in $50, you just made 50% on your money without any risk. Where are you going to find a comparable alternative? You can’t.

Finally, since your 401k grows tax deferred, your money really does grow much faster. Think about it. If you earn $100 and invest it in your 401k, that entire amount gets invested because there will be no reduction for tax. But if you earn $100 and fail to contribute to your 401k, that money will be taxed. That means you’ll have $70 working for you instead of $100 (assuming you are in the 30% bracket).

The more time you have to invest in a 401k before you retire the more powerful all these “pros” are.

Why You Should Not Contribute to a 401k

There are several reasons why you should not invest in a 401k retirement plan. 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.

Assume 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.

Other reasons for not putting money into your 401k include:

  1. 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.
  2. 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.People use this reasoning every once in a while and to be frank, I don’t buy it. How does anyone know what their tax rate will be 5 plus years down the road? You might think you know but the sad truth is that nobody really knows what’s going to happen with taxes (or anything) in the future.
  3. 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. Your 401k contributions are generally held by a retirement custodian and that is usually a strong financial institution. That is why, 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.

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

But most employers have a very wide selection of investment options in the plan. If you are frustrated by your 401k performance, it could be that you aren’t selecting the right 401k investments.

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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