401(k): Do it even without a match

NEW YORK (Money) -- Question: My company 401(k) plan has no match. So I'm debating whether I'd be better off contributing to the plan or instead just buying index funds on a monthly basis. What do you think? - Matthew

Answer: It's definitely a drag having a 401(k) that doesn't kick in matching funds, since a match over the course of a career can easily boost your account's balance by a third or more. Maybe you and a few other employees should gently suggest to your HR department that your company join the vast majority of firms that offer some matching 401(k) contribution.

But even without the match, I think you would be making a mistake by blowing off your 401(k). For one thing, its sheer convenience, with the money taken out of your paycheck before you get a chance to spend it, is tough to beat. Sure, you can plan to invest in index funds, or any other option, on your own. But will you do it month after month, or will life's little "necessities" intervene?

You're also contributing pre-tax dollars, and your money compounds without the drag of taxes, which can give your 401(k) an edge over just investing in taxable accounts.

Let's look at a simple example. Say you have $10,000 that you can invest in a 401(k) without a match or in an index fund in a taxable account. And let's assume you're in the 25 percent tax bracket and that you earn 8 percent a year on both accounts.

After 10 years, your 401(k) balance would be $21,589. Assuming you'd owe 25 percent in taxes, that would leave you with $16,192. If you decided to put your money in the taxable account, you would have only $7,500 to invest because you would owe $2,500 in taxes on your $10,000, assuming a 25 percent tax rate.

Over 10 years at 8 percent a year, your $7,500 would grow to $16,192. Now even if we assume all of your gain is taxed at the long-term capital gains rate of 15 percent - which isn't likely since the fund will probably throw off at least some taxable distributions in the course of 10 years - you would owe $1,304 in taxes, leaving you with $14,888, or $1,304 less than you would have in the 401(k) after taxes. In short, the difference between the two options is the extra tax you must pay on the gains in the taxable account. (Five 401(k) flubs to avoid)

Now, this difference can narrow or even reverse if you pay a higher tax rate when you withdraw the money from your 401(k). But for the taxable account to begin looking better in any sort of significant way, you would have to move up all the way to the top tax rate of 35 percent. And, again, that assumes all of your gains in the taxable account are taxed at the low rate of 15 percent.

In reality, your actual rate is likely to be a bit higher. To me, this suggests that you're likely better off doing the 401(k), especially when you factor in the automatic payroll deductions, which make it far more likely you'll actually save the bucks than you would in an outside account.

In fact, before you even consider contributing to a taxable account, I think you should first contribute the max to a Roth IRA ($4,000 this year, $5,000 next, plus an extra $1,000 if you're 50 or older), assuming you're eligible, which you can check by clicking here.

As with a taxable account, you contribute after-tax dollars to a Roth. But with a Roth, you pay no tax on your contributions and gains when you withdraw them, assuming you meet the criteria for tax-free withdrawals. So you're essentially getting a tax-free return on the Roth, which makes it a better deal than the taxable account.

So I suggest you consider contributing to your 401(k) and, if you can afford it, also doing the Roth. Having both types of accounts also allows you to diversify your future tax exposure a bit.

Remember how in the example above the 401(k) became less attractive if you faced a higher tax rate when you withdrew the money versus when you put it in? Well, the Roth works the opposite way. A Roth is a better deal if you face a higher tax bracket later on. The reason is that you would be paying taxes at today's lower rate and avoiding tax at a higher rate at withdrawal.

And since it's difficult to gauge what tax rate you'll face in retirement many years down the road, the combination of a 401(k) and a Roth lets you hedge your bets.

Of course, you'll always want to have some savings in taxable accounts that you can tap for needs other than retirement. And for that money, I think your plan of investing in index funds makes eminent sense, both because of their tax efficiency and their low cost. (Indeed, there's no reason you shouldn't also invest in index funds in your 401(k) if they're an option. And you can certainly fund a Roth IRA with index funds.)

But as far as your retirement savings are concerned, I'd recommend going with the 401(k) first, then a Roth, and only after maxing out on those alternatives moving to taxable accounts.

Oh, one more thing. If your plea to add a match to the 401(k) at your present job comes to naught, keep your eye out for an opening where the 401(k) is more generous. Because come retirement time, those matched funds can mean the difference between living and living large.