A reader wrote in this week to ask:
“Considering the current plight of the stock market, do you still recommend 20-somethings max-out contributions to their 401k’s, or should they invest in something safer like a high-interest savings account instead?”
Should You Contribute to Your 401(k)?
The question of whether or not to contribute to a 401(k) doesn’t have anything to do with the stock market. I’ve yet to see a 401(k) plan that didn’t offer a single bond fund, and most plans even offer a very low-risk option such as a money market fund or a stable value fund. In other words, you can contribute to a 401(k) without investing a dime in the stock market.
So the primary question is this: Is this money intended for retirement? If so, it’s probably a good idea to take advantage of the tax breaks that come with investing via retirement accounts.
That said, there are some circumstances in which it makes sense to contribute to a Roth IRA before maxing out your 401(k). Specifically (assuming you’re eligible to make them) Roth IRA contributions should be a higher priority than 401(k) contributions if:
- Your employer does not offer a matching contribution (or you’ve already contributed enough to get the maximum match), and
- You expect your tax bracket in retirement to be greater than or equal to your current tax bracket.
Update: As has been noted by a couple savvy readers, an additional advantage of Roth IRAs is that contributions can be withdrawn free from tax and penalty at any time.
Alternatively, contributions to a traditional IRA should be the highest priority if:
- Your income is such that you’re eligible for deductible contributions to a traditional IRA,
- Your employer does not offer a matching contribution (or you’ve already contributed enough to get the maximum match),
- You expect your tax bracket in retirement to be lower than your current tax bracket, and
- The investment options in your 401(k) aren’t as good as those you would have access to in an IRA.
Should You Be Investing in Stocks?
As to the implied question of whether or not it makes sense to invest in the stock market, I don’t think that’s changed at all in the last month. The stock market was high-risk, and it still is high-risk. At the same time, it still has higher expected long-term returns than other asset classes.
So, for most 20-something investors, yes, I still think it makes sense to have some of their assets allocated to stock funds. But how much should be allocated to stocks varies from person to person. Some investors are risk-tolerant. Some are risk-averse. There’s nothing wrong with either one–it’s just important to understand which of those two you are, so that you can invest accordingly.
In other words, if you’re feeling the need to use a more conservative asset allocation in the future, that may be a good idea. But, as we discussed last week, remember not to hike the risk level back up (by moving more back into stocks) when stocks start to rise again, otherwise you’ll be setting yourself up for another selling-during-a-downturn scenario.