Saving for retirement is a mystery to most people that is filled with acronyms, percentages, and far too many numbers. But understanding how to save for retirement is key to achieving your retirement goals. This includes making an active decision on how much you should put into your 401(k) account. Should you put in the maximum amount if you can afford it? Or does it make more sense to put your money somewhere else, such as stock trading apps? Read on to learn more about 401(k)s and whether or not you should max out your account.
What is a 401(k)?
A 401(k) is a retirement savings plan that is typically established by an employer for the benefit of employees. It is funded by contributions from the employee, and in many cases, matching contributions from the employer of up to a certain percentage. The funds in the account are then invested in a variety of ways such as stocks, bonds, mutual funds and money market funds. Each year, the IRS establishes a limit on the total maximum contribution to a 401(k) plan. In 2017, the contribution limit is $18,000. Employees of age 50 and over can contribute an extra $6,000 per year to “catch up” their account.
401(k) plans are an attractive option for retirement savings because they have tax advantages. Both contributions to the account and earnings on the account are not taxed until they are distributed at retirement. This means that employees can defer income taxes on this money until after they have reached retirement age — when they will likely be in a lower tax bracket. However, early withdrawals from a 401(k) account can result in significant taxes and penalties.
Maxing Out Your 401(k)
Maxing out your 401(k) means contributing the highest amount that you can for the year: $18,000 for employees under age 50 and $24,000 if you are age 50 or older. The answer may seem simple — that you should put as much as possible into your retirement savings as possible to defer taxes and to be able to retire comfortably. However, putting the full amount into your 401(k) account isn’t always a smart idea — especially if you don’t have a robust emergency savings fund.
An emergency fund is a savings account where you can set aside money in the event that you lose your job or have something unexpected happen. Ideally, you should have six months of living expenses in your emergency fund. If you don’t have this amount in your emergency account, you should not max out your 401(k). Putting your money into a 401(k) ties it up until retirement; you won’t be able to withdraw it before then without incurring taxes and penalties. Having cash readily available is important for your financial security and health. Make sure that you maintain flexibility by having a well-funded emergency savings account before contributing the maximum to your 401(k).
If you have an emergency fund set up, then you should consider a few other items before deciding to put the top amount into your 401(k). At a minimum, you should contribute enough to your 401(k) to get your employer’s matching percentage (which is basically free money!). If your employer will match your contributions up to 5% of your salary, for example, then put in that 5%. After that amount, you can decide if it makes sense to put the full amount into your 401(k) or invest the money elsewhere.
Depending on your salary, age and financial situation, you may be better off investing in vehicles other than a 401(k). For example, a Roth Individual Retirement Account (IRA) is a better choice for anyone in a lower income bracket; you pay taxes on the money before it goes into your account, and then both the earnings and the distributions are tax-free.
You can pay the taxes now when they’re more affordable, and you have fewer obligations later and can enjoy tax-free growth and distributions. Roth IRAs also give you greater options in directing how your money will be invested and they typically have lower fees than 401(k)s. However, if you make over a certain amount of money, you will be ineligible for this type of retirement account. It may then make more sense to put the maximum amount of funds into your 401(k) where it will grow on a tax-deferred basis.
If you are in your 20’s, it may not make sense to max out your 401(k), depending on your retirement goals. You can make smaller contributions to your 401(k) when you start at a younger age since the money will grow over time. You can then direct more of your income towards saving for a home putting money into other investments or to other financial goals. If you are older — such as in your late 30’s — and need to catch up on your retirement savings, then it may make more sense to put the maximum amount into your 401(k). You’ll need to “catch up” on retirement savings in order to be able to comfortably retire at your desired age.
When it comes to maxing out your 401(k), there is no one-size-fits-all answer. It truly depends on a number of factors, and will vary considerably based on things like your current age, salary and how much you need to set aside for retirement.