You can do more than max out your 401(k) to secure your dream retirement.
Maxing out your 401(k) is a financial milestone to celebrate. Not everyone can set aside $20,500 or more toward retirement in a single year. That contribution level puts you ahead of the average retirement saver and on a great path to funding the retirement you want.
Still, in some scenarios, maxing out your 401(k) can limit your financial flexibility later. Read on to learn about three of those scenarios and how to avoid them.
1. You might miss some employer match
Your employer match works this way: For every dollar you contribute, your employer matches your contribution in a defined ratio. Commonly, the ratio is either $1 or $0.50 in match for every $1 you contribute.
Max out your 401(k) prior to year-end and you’ll have at least one pay period in which you contribute nothing. If you don’t contribute, you don’t earn your match for that pay period. The only exception is if your employer trues up your match at year-end based on your cumulative contributions.
The fix is to spread out your contributions across all pay periods. Admittedly, this can be tricky to plan, especially if you earn a bonus or two throughout the year. One way to manage it is to set an estimated contribution rate in January, and then adjust quarterly. Your goal is to reach the IRS’ maximum contribution limit in your last pay period.
2. You might miss tax diversification opportunities
As you probably know, your traditional 401(k) has a specific tax structure. The contributions are tax-free, and your distributions in retirement are taxable. Your Social Security income will also be taxable if you are taking larger distributions from your 401(k). When the bulk of your retirement income is taxable, you have no control over your annual tax bill.
The solution is to cultivate nontaxable sources of retirement income alongside your traditional 401(k). You’d do this by contributing to a health savings account (HSA) and/or a Roth account if you qualify. An HSA allows you tax-free distributions for medical expenses. Roth distributions in retirement are tax-free for any purpose.
With those alternative income sources on hand, you can blend taxable and nontaxable income to manage your annual tax liability. Think of this as a tax diversification strategy for your senior years.
3. High fees cut into your returns
Most 401(k) plans pass fees along to the accountholders. According to the National Association of Plan Advisors, these annual fees range from 0.88% to 1.19% of your account balance. While fees do cut into your investment returns, most savers tolerate them because of the other perks a 401(k) provides — namely, convenient investing and employer match.
Fees become problematic when they’re higher than that average range. If your plan is charging you something close to 2%, for example, you could be losing 20% or 30% of your average annual returns to fees. That assumes your funds are growing in line with the stock market as a whole.
If this is happening to you, consider investing outside of your 401(k) after maxing out your employer match. Your choices are a low-fee HSA, Roth IRA, traditional IRA, or a taxable brokerage account.
Allocating funds to various retirement accounts
Spreading out your retirement contributions is admittedly more complicated than putting all your eggs in the 401(k) basket. Deciding how much goes where can be the hardest part. To build a good mix of taxable and nontaxable sources of retirement income, you might prioritize your contributions like this:
- Contribute at least enough to your 401(k) to get your full employer match.
- Then max out your available HSA contributions.
- Then max out Roth IRA contributions if you qualify.
- Then, with any remaining available funds, max out your 401(k). Or, if your 401(k) has high fees, invest in a taxable brokerage account instead.
Target maximum flexibility in retirement
For improved financial flexibility in retirement, go beyond maxing out your 401(k). Collect every dime from your employer match, invest in tax diversity, and manage those fees. Together, those three steps can turn a good retirement into a great one.
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Source: The Motley Fool