Retirement is a great time for many people because it gives them a chance to enjoy the fruits of their decades of labor and live on their own terms. Regardless of your ideal retirement, there's a good chance you'll need a decent nest egg to enjoy it how you really want.
One of the best ways to ensure this is by taking advantage of retirement accounts, particularly a 401(k). A 401(k) offers the chance to save money for the future and in the present by lowering your taxable income.
In an ideal world, everyone would make enough money to max out their 401(k) while meeting current financial obligations and goals. Unfortunately, that's not the case for most people. For many people, maxing out a 401(k) may be a mistake. Here's why.
Image source: Getty Images.
You should focus on an emergency fund first
There's a reason that retirement accounts are considered retirement accounts: The money inside is intended to stay there until retirement. That doesn't stop life from happening, though. That's why it's hard to overstate the importance of having an emergency fund available. It's your safety net in case an unexpected (and costly) dilemma pops up.
The goal should be to have anywhere between three to six months' worth of living expenses saved up for your emergency fund. People only responsible for themselves can be comfortable with a few months' worth, but folks with families should lean toward making six months' worth their goal.
Before maxing out your 401(k), prioritize saving up an emergency fund. Contribute enough to get your employer's match, but focus on building your savings afterward. Sometimes, withdrawing from your retirement account is the only option, but doing so is expensive when you consider the 10% early withdrawal fee. Having an emergency fund can help solve this.
A Roth could help with your tax bill in retirement
A traditional 401(k) has tax-deferred growth, meaning your investments grow without being taxed. However, the key word there is "deferred." When you take 401(k) withdrawals in retirement, you'll owe income taxes on the money. Depending on how much you have in your 401(k), withdrawals could push you into a higher tax bracket and increase your tax bill more than expected.
Having a Roth IRA could allow for tax diversification. Unlike a traditional 401(k), you contribute after-tax money into a Roth IRA and then take tax-free withdrawals in retirement. If a large 401(k) withdrawal would push you into a higher tax bracket in a given year, you could withdraw from your Roth IRA instead and control your taxable income.
A 401(k) has required minimum distributions beginning at age 73, so you want to at least withdraw that much when the time comes, but if you want to keep your taxes to a minimum, you could use a Roth IRA to cover the remaining money you need to cover living expenses.
Keep in mind that some employers offer Roth options within their 401(k) plans. In that case, you can get many of the benefits of a Roth within your 401(k).
Withdrawal flexibility can be underrated
You can withdraw any contributions, but not earnings, from a Roth IRA anytime without facing the 10% early withdrawal fee. There are some notable exceptions to the rule that alone make it worth taking advantage of before focusing on maxing out your 401(k).
To begin, you can take withdrawals for qualified educational expenses for you, your spouse, or your children. Qualified educational expenses include tuition, fees, and books but don't include room and board, insurance, or living expenses. You can also withdraw up to $10,000 toward purchasing your first home, which could account for a decent amount of the down payment or associated fees.
Roth IRAs are designed to essentially be brokerage accounts with good tax benefits. So, if you're saving up for a home or your kid's college fund, a Roth IRA could be a good choice to park some savings to try to grow them before that time.
A retirement savings approach
Although maxing out your 401(k) may be a mistake, using one isn't. It's a great retirement plan worth taking advantage of. There are plenty of ways to approach retirement savings, but here's one order I recommend:
- Contribute the percentage that will allow you to get the maximum employer match. If your employer matches up to 5%, 5% should be your minimum contribution. Anything less is leaving "free" money on the table.
- Contribute to an IRA, assuming that you have an emergency fund built up. The maximum IRA contributions for 2023 is $6,500 ($7,500 if you're 50 or older), so it won't take as much to max out an IRA compared to a 401(k).
- Return to your 401(k) and increase your contributions as you see fit.
This process allows you to take advantage of the best of both worlds. You get the tax benefits of a 401(k) as well as the flexibility that comes with an IRA.
