If you're aiming to supercharge your retirement savings, maxing out your 401(k) or IRA may sound like a smart move. As of 2020, you can contribute up to $19,500 per year to your 401(k) and $6,000 per year to a traditional or Roth IRA, and that money can go a long way toward saving for retirement.
However, if you have cash to spare, throwing it in your retirement fund isn't always the best idea. Here are three reasons you may not actually want to max out your retirement accounts.
1. You could put more money toward an emergency fund
An emergency fund is more critical than ever, so if you don't have at least three to six months' worth of savings socked away, it's wise to make building an emergency fund a priority. In some cases, an emergency fund can actually help you save more for retirement.
Unexpected expenses will inevitably pop up sooner or later, and if you don't have any emergency savings, you may be forced to tap your retirement account. However, withdrawing money from your retirement fund can be costly, both in the short term and in the long term.
Typically, you're subject to a 10% penalty and income taxes on the amount you withdraw before age 59 1/2. Additionally, every time you take money from your retirement fund, that's money that is no longer able to grow and compound. Withdrawing even a few hundred dollars now might result in missing out on thousands of dollars in potential investment gains, and if you're repeatedly dipping into your retirement savings, you could hurt your chances of retiring comfortably.
2. You could pay off expensive high-interest debt
High-interest debt (such as credit card debt) can be incredibly toxic if allowed to snowball. The longer it takes you to pay off this type of debt, the more you'll accrue in interest. Eventually, you could end up paying more in interest than you owed in the first place.
If you're maxing out your retirement account, that's less money that can go toward your debt. And depending on how much debt you have and how much you're saving for retirement, you could potentially be paying more in interest on your debt than you're earning on your retirement investments. In that case, putting any extra money you have toward your debt could actually help you save more for retirement in the long run.
3. You could divide your savings between retirement accounts
If you have access to both a 401(k) and an IRA, it may be wise to split your savings between them rather than maxing out one or the other. Both 401(k)s and IRAs have their advantages and disadvantages, and by investing in both types of accounts, you can make the most of your money.
For example, one significant advantage of a 401(k) is that many offer employer matching contributions -- which are essentially free money. However, the drawback is that they often don't offer many different investment options, and they could also charge higher-than-average fees. What you could do, then, is contribute enough to your 401(k) to earn the full match from your employer, then stash the rest of your savings in an IRA that offers more investment choices and lower fees.
Maxing out your 401(k) or IRA can be a smart move in some situations, but it's important to consider all your financial responsibilities to ensure you're putting your money in the right places. By strategically building your savings and paying off debt, it will be easier to save more for retirement.