I remember playing sports and hearing my coach repeat the phrase, "Don't forget the five [Ps]: Proper preparation prevents poor performance." It's a phrase that has stuck with me even now that those days are long behind me. It's also what I keep in mind when I think about preparing for retirement.
For a while, my idea of properly preparing for retirement was setting a goal to get to the point where I could max out my 401(k) each year. It's a common goal many people have, even if it means sacrificing other financial opportunities.
However, I've learned that although the thought of maxing out a 401(k) sounds appealing, the unfortunate truth is that it's a bit of an overrated goal for people who don't have the means to max out both a 401(k) and an IRA.
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Many people value being able to tailor their portfolios
One of the biggest cons of a 401(k) is the limited choice of investment options. You can't invest in any stock or bond you want to in your 401(k); you're restricted to the options given to you by your plan provider. In many cases, this includes your company's stock (if it's a public company), a set of index funds and bonds, and target-date funds that automatically rebalance to become more conservative as you get closer to retirement.
On the other hand, IRAs -- both Roth and traditional -- allow you to invest in virtually anything you could in a typical brokerage account, with a few exceptions, like certain types of derivatives.
Ensuring a retirement portfolio matches your risk tolerance, investing style, and time horizon is important, but you can't guarantee that you can accomplish this with your plan's investment options. The freedom of an IRA allows for a more flexible investment strategy.
IRAs have more flexibility when life throws a curve ball
It'd be nice if life was always peachy keen and everything went as smoothly as planned, but that's unfortunately not always the case. In an ideal world, the money you contribute to a retirement account would stay there until you retire, but life happens, and you may need to withdraw from one of your retirement accounts.
Making an early withdrawal from a 401(k) would result in a 10% early-withdrawal fee and income taxes owed on the withdrawn amount. Depending on how much you withdraw and your tax bracket, this could cause you to lose a good chunk of the money.
IRAs also have penalties for early withdrawals, but they offer more exceptions. For example, you can avoid the 10% penalty if you use the money for a first-time home purchase, qualified education expenses, unreimbursed medical expenses exceeding a certain amount, or health insurance premiums while you're unemployed.
This flexibility can come in handy during large life events, such as buying a house or paying for a loved one's college tuition, or large unexpected events.
Maxing out a 401(k) may be overrated, but contributing to one isn't
There's no doubt that one of the best tools available when saving for retirement is a 401(k). There are plenty of pros to contributing to one, including the chance to lower your taxable income, the passive nature of it, and employer matches. I don't want you to confuse maxing out the account being overrated with contributing to one being overrated.
My personal preference for contributing to both a 401(k) and IRA is the following:
- Contribute the maximum amount your employer will match and not a penny less. An employer match is essentially "free" money and works as an automatic 100% return on your contributions.
- Prioritize maxing out an IRA.
- Once your IRA is maxed out, shift focus back to increasing your 401(k) contributions.
If you can max out both a 401(k) and IRA without jeopardizing your livelihood, by all means, do it. That's an ideal situation. For most people, though, it's not feasible. The above strategy puts someone in a position to take advantage of the pros of each account while offsetting some of their downsides.
