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WHEN MAXING-OUT YOUR 401K MAKES NO SENSE

A 401(k) plan is a popular way to save for retirement.  It is sponsored by an employer and everyone in the company is incentivized to participate in the plan.  If you participate in your company's plan, I want to first recognize that you've taken an important step towards securing a good retirement by saving money today.  Saving money isn't easy and despite all the distractions, you've made it happen.  Congratulations! 


There are many great features of a 401(k) plan that make it an important component in retirement success strategies.  Contributions are automatically deducted from each paycheck, which is very handy for those who struggle with the discipline of saving.  Contributions are deductions for current year's income tax. This reduces exposure in the top marginal bracket.  Company match also sweeten the deal.  


However, the 401(k) plan is also heavily regulated and restricted by the IRS, making it unfit in many situations.  This article explores some of these instances when over-reliance on 401(k) plans does not make good financial sense. 


When you have not sufficiently protected your todays. As matter of principle, your financial house today must be protected first, fully, and forever.  The further along you've come, the longer you've been building your fortune the more important this is.  All the major areas, including car, home, liability, long term care, disability, medical, legal, and your full human life value should all be properly protected.  Unexpected life events happen to everyone.  Some are concerned about the additional cost to achieve full protection.  Do not take this unnecessary risk.  Other strategies can be used to replace any lost income in retirement due to protection costs.


When you are short on liquidity.  In my practice I recommend families having short-term savings equal to 6-18 months of expenses.  You can use cash, money market, life insurance cash value or other easily accessible sources.  This money provides safety and liquidity, and allows you to quickly react to unexpected changes or opportunities in life.  Among many things, when determining the appropriate amount, you should consider how long you realistically expect to find another equal or higher paying position, should you loose your job.  A generous home equity line should not be used as a substitute as it increases your monthly mortgage payment and is susceptible to recall.   


When saving for retirement is in competition with down payment for your first home. Young professionals ask me this a lot, "how am I supposed to manage a down payment when everything else costs so much?”  This is especially true in the Bay Area where housing prices are among the highest in the nation.


A primary residence is more than just a house.  It's a place you call home, raise a family, entertain your friends and create wonderful memories.  For many, owning a home still symbolizes the realization of The American Dream.  It's a milestone that recognizes all of your hard work and all of the sacrifices that you have made throughout the years.  In my opinion, if you have to make a choice between funding retirement and buying a first home the latter should be prioritized.


When you are carrying short-term debt like credit card or certain student loan.  Paying down an 8% loan is better than investing with an 8% return because there is no risk!  Short-term debts with high interest rates are significant roadblocks to wealth building. The sooner you pay them off the better. 


When you only have income-tax deferring type of financial instruments.  These include 401(k) plans, IRAs, Deferred Compensation Plans and others.  In retirement, income from these sources is taxable as "ordinary income.”  Lack of tax diversification could expose you to an increased liability if tax rate rises in the future or if you desire higher income and improved life style in retirement.  What a dilemma that is!  Tax-free sources of retirement income should be considered.  

Lets shift the paradigm a little and consider the psychological effect of maxing out a 401(k).  According to The Living Balance Sheet® a savings rate of 15% serves as a prudent starting point to building s secure future.  For many highly compensated professionals in Silicon Valley, maxing out a 401(k) gives the illusion that enough has been done and that the market itself is going to get the job done given enough time while ignoring the risk.  This is a grave misunderstanding of how wealth building works.  Robert Merton, a recipient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences and a professor of Finance at the MIT Sloan School of Management, explores more on why the common approach towards saving is all wrong.  His ideas are collected in the article The Crisis in Retirement Planning published in the July-Aug 2014 edition of the Harvard Business Review.


Saving for retirement is s critical component in your financial life,  regardless where you are today. Start a conversation with a financial professional, learn from the experience of those who came before you, think critically, and act decisively.   

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