Should I Max Out My 401K?

Should I Max Out My 401K

This question often gets answered quickly with little thought and a simple, “Yes!  Defer taxes for as long as you can.”  However, depending on how much you need to save for retirement, your income and a variety of other factors, you may actually want to fund other accounts before depositing the full $18,000 in your 401K.

We’ll start with two “givens” that are true for everybody and then work through some additional questions you can ask to help you answer, “Should I max out my 401K?”

Given #1 – Fill Up Your Emergency Fund First

Before even thinking about retirement savings, make sure you have your Emergency Fund topped up first.  I recommend having at least six months of living expenses set aside in a separate bank account for when life throws you the inevitable financial curve ball.

Given #2 – Grab the Company Match

Your next step is to make sure you’re contributing at least as much as your company is willing to give you in matching contributions.  So for example, if your employer is willing to match up to 6% of your salary; then make sure you’re putting away the full 6% into your 401K because that’s free money!

Things get more complicated from here.  Here are a couple of questions to ask yourself to help work through how much additional money you should contribute to your 401K.

How Much Do You Need to Save for Retirement?

In general, the earlier you get started, the less you need to save for retirement.  Let’s say you’re in your 20’s and have determined you need to save 12% every year to meet your retirement goals.  If you’re working for the very generous company cited in the example above, you can simply contribute 6% to your company 401K, grab the 6% match and make no further contributions.

Additional savings can be used to save for a down payment on a house, college tuition for your kids or tucked into a Roth IRA to grow tax free.

Or perhaps you’re getting a later start in your late 30’s, have met with your financial advisor and determined that you need to save 21% of your income toward retirement to meet your goals.  If your employer matches a less generous 3% of your salary and you make $100,000 a year, you could meet your goal by making the maximum 401K contribution of $18,000 along with the 3% match.

However, before you get on your company’s website and crank your contribution up to the maximum, it may actually make sense for you to fully fund your retirement with a combination of contributions to both your 401K and a Roth IRA.  Here are three reasons why:

1.) If you are in a relatively low tax bracket now, it probably makes sense for you to pay taxes in this lower bracket rather than saving all of your money in your tax deferred 401K only to end up paying at a higher rate in retirement.

2.) Many 401K plans have limited choices and high fees associated with them.  You can either invest yourself in a Roth IRA or work with a qualified financial advisor to help you construct a well-diversified portfolio of low-cost ETF’s.  This will give you a much wider range of choices while also keeping your investment costs lower and more of your hard-earned money growing on your behalf in your account.

3.) Having some of your savings in tax-deferred accounts and some in tax-free accounts gives you maximum “tax flexibility” as you approach and ultimately enter retirement.  There is no single right answer for everyone; however, as a general rule, consider having 60-80% of your savings in tax deferred accounts (like your 401K) and 20-40% in tax-free accounts (like a Roth IRA).

Now, one final question before you make a call on how much to tuck away into that 401K.

How Much Money Do You Make?

If you’re single with a modified AGI in excess of $132,000 or married with a MAGI over $194,000, you are not allowed to contribute to a Roth IRA.  In this instance, it probably does make sense to max out your 401K and contribute the full $18,000.

If you’re still looking to shield additional income from taxes, you can consider investment real estate and certain life insurance products but we’ll need to leave that discussion for another day.

Good luck working your way through your decision on how much to contribute to your 401K and with all of your retirement and savings goals!

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