By Lloyd Yamada, CFP®
Have you heard the mantra to max out your 401(k) contributions? I cannot tell you how often I have heard people on television, colleagues, and friends say this to me. Read on to see why, in some cases, this approach may not be in your best interests.
It is almost always a good idea to contribute to an employer-sponsored 401(k) or similar plan if one is available to you. Your contributions reduce your taxable income; thus you reduce your taxes. The funds are also taken from your paycheck, which makes contributing easier to do.
The question is not whether to contribute but how much to contribute. If your employer matches a portion of your contributions, then it is even more beneficial for you to contribute the minimum needed to receive the maximum matching contribution. The amount will depend on the specifics of your plan, so consult with a trusted advisor or your HR department.
Despite the advantages noted above, there may be reasons why you do not want to maximize your contributions to a plan. Here are just some of them:
- Your personal situation may dictate no need to reduce your salary for tax reasons.
- Your employer’s plan may not offer a diversified and cost-efficient set of investment options.
- Your current income may not support a maximum contribution amount.
Another important reason is the advantage of not building a future portfolio with a heavy emphasis on tax-deferred accounts. It is preferable to build a portfolio of several kinds of accounts, such as taxable, tax-deferred, and tax-free accounts. No one knows what their financial situation will be in the future. You may have a pension; you may not. You may be fortunate enough to receive an inheritance. You may want to leave a full-time position for a part-time one. There may be years when your taxable income is high and others when it is lower. Having different types of accounts gives you the flexibility to choose where your income is coming from to minimize your tax impact in that year.
Instead of waiting to establish the three types of accounts, by redirecting contributions from a 401(k) to Roth IRA accounts (if available to you) or to taxable savings or investment accounts, you can begin to diversify the types of accounts that are part of your overall portfolio.
Building a portfolio that is diversified by account type and by appropriate asset classes is no easy task. Care should be exercised in an analysis of your cash flow, tax situation, current net worth, and goals before making decisions on how much to contribute to your 401(k) versus a Roth IRA versus a taxable account, and how to allocate investments in those different accounts to match your goals and risk tolerance.
So when you next hear from friends or colleagues that you should always max out your contributions to a 401(k) account, you will know that the mantra is not always true or in your best interests.