Saving for retirement is generally seen as a responsible move, and it often is, but there are times where locking your savings away in a retirement account could hurt you more than it helps. Before you put money into a 401(k) or IRA, ask yourself these three questions.
1. Is this the best use of this money?
Retirement savings should be high on your priority list, no matter what age you are. But there are a few things that should be even higher on the list. Everyone should have an emergency fund containing three to six months' worth of living expenses to cover unexpected costs like medical emergencies, home repairs, and meeting your insurance deductible. Without this fund, it's all too easy to fall into debt when an emergency comes up.
Put your extra savings into an emergency fund first before you start saving for retirement. Once the money's locked up in your retirement account, it's difficult to get back out again if you're under 59 1/2 without paying taxes or penalties. Leave your emergency funds in a separate savings account where you'll have easy access to them.
You may also want to prioritize paying down high-interest debt before or in conjunction with saving for retirement. High-interest debt can quickly spiral out of control, and many people find it difficult to get out of it. If you only have a small amount of debt, consider throwing all your extra savings at it until it's paid off. Then you can start saving for retirement. For a large amount of debt, try splitting your savings between debt repayment and retirement savings, but focus more on your debt until that's under control.
2. Will I need to access this money before I'm 59 1/2?
Typically, you can't withdraw funds from your retirement accounts before 59 1/2 without paying a 10% penalty tax, plus income tax if the funds come from a tax-deferred account. There are exceptions for first-home buyers, education expenses, and large medical expenses. You can also elect to take Substantially Equal Periodic Payments (SEPPs) from your retirement accounts for five years or until you turn 59 1/2, whichever is later. If any of these exceptions apply to you, you can withdraw money without penalty, but doing so will hurt the growth of your retirement savings.
You're better off keeping the money you intend to spend within the next three to five years in a savings account or in short-term investments, like a certificate of deposit (CD), rather than placing it in your retirement savings. This gives you easy access when you need the money without fear of penalties. Another option is to invest the money in a taxable brokerage account so it can still grow over time but you're free to withdraw it whenever you want. This is worth considering if you plan to retire before 59 1/2 and don't want to have to draw upon your retirement accounts early.
3. Is this account the best place for my money?
Once you've decided that putting your extra cash toward retirement is your best option, you then have to decide which type of retirement account is the best place for it. Start with your 401(k) if your employer matches some of your contributions. This could still be a smart place to stash your savings even if you don't get a 401(k) match because 401(k)s have higher contribution limits than IRAs -- $19,000 in 2019 compared with just $6,000 for an IRA ($25,000 and $7,000, respectively, for adults 50 and older).
Be mindful of account fees that may cut into your profits. You can find this out by checking your plan summary and your investment prospectus. You don't want to pay more than 1% of your assets in fees each year if you can avoid it. If your 401(k) charges more than this and you don't get an employer match, consider moving your money to a more affordable IRA instead.
You also have to ask yourself whether you want to use tax-deferred or Roth accounts. Tax-deferred accounts give you a tax break this year, but then you pay taxes on your distributions in retirement. You pay taxes on contributions to Roth accounts the year you make them, but after that, the money grows tax-free. Tax-deferred accounts usually make the most sense for those who believe they're in a higher tax bracket today than they will be in retirement, while Roth accounts are better for those in the same or a lower tax bracket today than they expect to be in the future.
Asking yourself these three questions before making any retirement account contributions will keep you from being ill-prepared for emergencies, owing penalties for early withdrawals, or making mistakes that hamper the growth of your savings. Make a habit of reviewing them before every contribution.