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Posted: April 23, 2009

401(k) plans: to fund or not to fund?

Careful consideration more important than ever

Wayne Farlow

If you are a small-business owner who provides a 401(k) plan to your employees, is the cost of providing this plan justified?  If you are an employee of a company that offers a retirement plan, should you participate in the plan? In our current economic environment, it is more important than ever to carefully consider your answers to these questions.

Business Owners

As a business owner, you feel a responsibility to provide the best possible benefits for your employees.  However, with current economic conditions, many small businesses can no longer afford to provide employer matching funds for their company-sponsored retirement plans.  Even without employer matching, you may still feel that it is your duty to provide your employees with a 401(k) plan.

As a small-business owner, the types of 401(k) plans that are available are often limited.  To keep the plan affordable, your plan may only provide a small number of mutual funds from a single family of funds. Typically, these mutual funds will have a front-end load (sales charge).
There are three problems with this type of 401(k) plan:

1. A front-end load provides for an immediate reduction in the investment returns for you and your employees.

2. If the number of mutual funds is limited, you may not be able to provide adequate diversification for you and your employees

3. The plan’s sales person may not have the training, knowledge and investment skills that are required to provide comprehensive investment advice on how to safeguard and grow your 401(k) investments.

If your plan has some or all of these drawbacks, examine your employee’s 401(k) contributions. You may find that most employees are contributing less than $5,000 per year to the plan. If that is the case, your employees will get the same tax-deferred benefits and much greater investment flexibility with a traditional IRA. 

If your 401(k) contributions are more than $5,000 per year, you must weigh your reduced amount of tax deferral against the cost and limitations of your plan. If the 401(k) is mainly for your employees, you may be doing them a favor by eliminating the company plan.

Employees 

If your company offers a 401(k) plan and you are under age 50,you may contribute up to $16,500 per year to the 401(k) plan plus an additional $5,000 per year to a Roth IRA.  Full Roth IRA contributions can only be made if your AGI (Adjusted Gross Income) is less than $105,000 as a single tax payer or less than $166,000 as a joint tax filer. Let’s assume that you qualify for both a 401(k) and a fully funded Roth IRA.
If your company offers a 401(k) with an employer match, try to contribute the full amount that the employer matches. This “free money” from your employer provides an immediate 100 percent return on your 401(k) investment. 

Now, let’s explore your options once you reach the employer match or if your company offers no employer matching funds. If your 401(k) plan comes with a wide range of no-load investment options and skilled investment advice, it is likely wise to fund your 401(k) plan to the maximum amount possible. However, if your company provides a limited number of mutual funds with sales charges (loads) and offers limited (or poor) investment advice, you may want to fund a Roth IRA up to the $5,000 ($6,000 if you are over age 50) maximum, before funding your 401(k).

A Roth IRA can be established with a discount brokerage firm such as Schwab, Fidelity or Vanguard.  You may then use no-load, low-cost mutual funds or exchange-traded funds (ETFs) for your investment vehicles. You or your investment adviser can establish a diversified portfolio that meets your investment goals and matches your risk tolerance levels.  Even though a Roth IRA contribution is not tax deductible, the contributions and investment returns can be withdrawn tax free during retirement.

Many larger companies have excellent 401(k) plans, offering low-cost, no-load funds, extensive diversification and skilled investment advice. However, if you own or work for a company where this type of plan is not available, consider your options. They are not as limited as you might think.

Wayne Farlow is the founder of Financial Abundance LLC, providing fee-only financial planning, asset management and retirement planning services. He is the author of “Financial Abundance Guide,” available at www.finabguide.com . He can be reached by email at finabguide@gmail.com or at 303-554-0309.

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Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor firm.  He is a Certified Financial Planner (CFP®), focusing on Retirement Planning, Investment Management, Small Business Owner Planning and Sudden Wealth/Inheritance Planning.  His book, “Financial Abundance Guide,” is available free at www.farlowfinancial.com .  He can be reached at wayne@farlowfinancial.com or at 303-554-0309.

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Readers Respond

I'm confused. The article says that a self-directed IRA has the same benefits of a 401(k). Not quite, I don't think. 401(k) contributions are pre-tax, effectively lowering one's taxable income. An IRA doesn't. By Mike T. on 2009 04 24

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