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Maxing out your 401(k) may sound appealing, but here’s the unfortunate truth about it

I remember I was working out and heard my coach repeating the phrase, “Don’t forget the five [Ps]: Good 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 ​​how to properly prepare for retirement was to set a goal to get to the point where I could max out my 401(k) every year. It’s a common goal that many people have, even if it means sacrificing other financial opportunities.

However, I’ve learned that while 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 resources to invest in both a 401(k) and a 401(k). to be used to maximum effect. ) and an IRA.

An older person walks next to a younger person holding a basketball.

Image source: Getty Images.

Many people find it important to be able to customize their portfolios

One of the biggest disadvantages of a 401(k) is the limited choice of investment options. You cannot invest in any stock or bond in your 401(k); you are limited to the options your subscription provider offers you. In many cases, this includes your company’s stock (if it’s a publicly traded company), a range of index funds and bonds, and target-date funds that automatically rebalance to become more conservative as you get closer to retirement.

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On the other hand, IRAs – both Roth and traditional – allow you to invest in virtually anything you can do in a typical investment account, with a few exceptions, such as certain types of derivatives.

Ensuring that a retirement portfolio fits your risk tolerance, investment style and time horizon is important, but there’s no guarantee you’ll be able to achieve 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 would be nice if life were always cheerful and everything went as smoothly as planned, but unfortunately that is 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 money from one of your retirement accounts.

Early withdrawal from a 401(k) would result in a 10% early withdrawal fee and income taxes due on the amount withdrawn. Depending on how much you withdraw and your tax bracket, this could result in you losing a good chunk of money.

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IRAs also have penalties for early withdrawals, but offer more exceptions. For example, you can avoid the 10% penalty if you use the money for the first home purchase, qualified education expenses, unreimbursed medical expenses over a certain amount, or health insurance premiums while you are unemployed.

This flexibility can come in handy during major life events, such as buying a house or paying for a loved one’s college tuition, or major unexpected events.

Maximizing a 401(k) may be overrated, but contributing to it is not

There’s no doubt that one of the best tools available when saving for retirement is a 401(k). There are numerous benefits to contributing to this, including the chance to reduce your taxable income, its passive nature and employer matches. I don’t want you to confuse maximizing an overvalued account with contributing to an overvalued account.

My personal preference for contributing to both a 401(k) and an IRA is the following:

  1. Contribute the maximum amount that your employer will match and not a cent less. An employer match is essentially “free” money and works like an automatic 100% return on your contributions.

  2. Prioritize maximizing an IRA.

  3. Once your IRA is maxed out, switch the focus back to increasing your 401(k) contributions.

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If you can max out both a 401(k) and an IRA without jeopardizing your livelihood, then by all means do it. That is an ideal situation. However, for most people it is not feasible. The above strategy allows one to take advantage of the advantages of each account while offsetting some of its disadvantages.

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The Motley Fool has a disclosure policy.

Maxing out your 401(k) may sound appealing, but here’s the unfortunate truth about it, originally published by The Motley Fool

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