You probably read this headline and immediately thought to yourself, “I have always been told to contribute to my 401k.” You wouldn’t be wrong; you have heard that a lot. In fact, we tell our clients that frequently. However, like any “blanket statement” you hear, it’s important to drill deeper. So, to answer the question “When should you not contribute to your 401k?” it’s important to know the benefits of a 401k.
With pensions becoming a thing of the past the onus is on us to save for our own retirement. Utilizing your company’s 401k can help you to do this. Depending on the way your company has set up the 401k plan you contribute a certain percentage of your salary either pre-tax or post-tax (see the difference here). Hopefully, your company then matches a certain percentage as well. That’s when contributing to your 401k is a no brainer, when you can receive free money from your company. What if your company doesn’t match or only matches a small amount? That’s when it becomes trickier.
If your company does not match any of your contributions or only matches a small percentage, you may want to consider contributing to a Roth IRA instead. A Roth IRA is a great tool for your overall financial plan that you can read about here. One point to note, in the scenario where your company matches a certain percentage, make sure to at least take the free money from the company. For instance, if you want to contribute 10% of your pay but your company only matches the first 3%, make sure to at least put 3% into your 401k. It can’t be repeated enough… Take the free money! Back to the Roth IRA, here are some benefits to be aware of.
First, as long as certain stipulations are met, a Roth IRA grows tax-deferred, and withdrawals are tax-free. This can give much needed flexibility when the time comes in retirement for taking income and planning for taxes.
Second, contributions are made after-tax which means that you could tap into your contributions, tax-free, if you ever needed money. Obviously the hope is that you budget properly and have an emergency fund so Roth IRA withdrawals aren’t necessary but life happens and sometimes you need to make that tough choice. If you only had a 401k at your current employer your ability to access funds would depend on if the plan allowed for in-service loans.
Lastly, when you have a Roth IRA there are a number of things that you can invest in. You figure out your proper risk tolerance and time horizon, then invest accordingly with a number of different options. In a 401k, it is common that your investment choices will be limited to what is available in that specific plan.
Another thing to consider is how much money you will be able to put away each year. The yearly contribution limits can help you decide where to allocate your savings. For instance, if you know you want to put away $600 a month, that is $7,200 for the year. If you are under 50 the limit for a Roth IRA for 2021 is $6,000, so once you meet that amount you will have to look at a different account. You can check out the limits for 2021 here. When you are considering where to allocate money it is important to think of all these factors. It could make a big difference in your overall financial plan. If you have questions or are looking for some professional guidance reach out to us at Redwood Financial Network. We’d love to help guide you in the right direction.