When it makes sense to stop adding money to a 401(k)

  • By David Blanchett,
  • The Wall Street Journal
  • 401(k)
  • Saving for Retirement
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  • 401(k)
  • Saving for Retirement
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There are roughly 100 million people in the U.S. today covered by defined-contribution plans such as 401(k)s, according to the Department of Labor. And each person has to figure out whether to participate in the plan and, if so, how much to save weekly or monthly.

The common advice is simple: Yes, participate, and save as much as possible. But while socking a bunch of money away in a 401(k) is a decent strategy, it's isn't necessarily always going to be the best one.

First, it's important to acknowledge that saving money isn't fun, at least for normal people. Who wants to save for retirement when you can buy the latest Apple gadget or go vacation on a beach? There aren't too many Instagram or Facebook posts with someone boasting about maxing out their 401(k)s. So, if you're going to endure the pain of savings, you need to save smart, and smart saving requires thinking both quantitatively and qualitatively.

Smart quantitative saving means considering the "effective return" of your money. The most attractive feature associated with saving in a 401(k) plan is the employer match. This is pretty much free money. For example, if there is a 50% match on the first 6% of deferrals in your 401(k) plan, the effective return on your first 6% of savings in the 401(k) is going to be 50% (the match) plus whatever you expect to earn on your investments. Let's call the total 55%. That's tough to beat.

The benefit of saving in a 401(k) changes considerably, though, beyond the employer match, and especially if the there is no employer match offered at all. Suddenly, there's no more free money.

The 5% return you might earn investing in the market is probably a lot lower than the 20%-plus interest rate you might be paying on your credit cards, and even the rates you might be paying on your student loan or home-equity loan. Interest rates are effectively negative rates of return. It doesn't make sense to try get a 5% return investing in the market while you're paying (aka losing) 20% interest on a loan.

There are other accounts worth considering instead of the 401(k), such as an individual retirement account or a health savings account. IRAs offer more flexibility for investors who may need to tap the money at some point for education expenses or a home purchase. HSAs offer the combination of saving pretax for qualified medical expenses and growing the unused money over time. A fellow Experts blogger covered the tax benefits of HSAs, which is definitely worth a read.

Smart qualitative savings, meanwhile, has to do with how certain types of savings make you feel, especially if it results in you increasing total savings levels.

I have a personal example. My wife and I still have a lot of student loans from graduate school. Getting the degrees was definitely a smart investment, but I (and we) hate having these debts. So, despite the fact that the loans carry very low interest rates (we've refinanced a few times), we're aggressively paying these loans down--instead of putting that money toward additional retirement savings, such as beefing up our 401(k)s. Our approach might not be optimal from a quantitative perspective, given the low interest rates on the loans, but we hate having the debt and knowing that we're paying them down motivates us.

In other words, you should ask yourself: What financial goals mean the most to you? If you're willing to save more to have a better chance at achieving these goals, the quantitative aspects of potentially saving in a 401(k) becomes less important. I'm not saying to forget saving for retirement, but for most people the amount saved is going to matter a lot more than the return on those savings.

Let's say you have two options: Save $5,000 and earn a 10% return or save $8,000 and earn 0%. With option 1, at the end of the year, you'll have $5,500 saved. With option 2, it's $8,000. The return on those savings is lower, but you've done more to improve your financial situation.

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