The Common 401(k) Advice Retirement Savers Should Take With a Grain of Salt

How much should you contribute to your 401(k)? Experts often say you should contribute 10% to 15% of your salary.

Saving and investing 10% or 15% of your income in a 401(k) can produce a sizable nest egg over time, but guess what? There are situations when that rate is too high for your 401(k). Read on to learn about four of those situations and what you can do instead.

1. You’re targeting an early retirement

401(k) withdrawal rules cater to those who retire in their late 50s or early 60s. Normally, any 401(k) distributions you take before age 59 and a half are subject to a 10% early withdrawal penalty. There is an exception for workers who leave their jobs at age 55 or older.

But if you retire earlier than 55, you’re subject to the 10% penalty on withdrawals until you are 59 and a half. Unless you want to take the 10% hit, you’d need assets stashed outside your 401(k) to pay the bills temporarily.

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You can preserve your flexibility to retire early by saving less to your 401(k) and more to another account. You could invest within a taxable brokerage account, for example. This account type has no early withdrawal penalties, but you do pay taxes annually on realized gains, dividends, and interest.

A second option is to save the excess funds to a Roth IRA if you are eligible. You can withdraw your contributions from a Roth IRA at any time. Only the earnings are subject to withdrawal restrictions.

2. Your 401(k) is mediocre

Some 401(k)s have high administrative fees that cut into your returns. Others have marginal or high-fee investment options that underperform relative to the stock market. If your 401(k) is expensive or has limited fund options, you can often earn more on the same contributions by investing elsewhere.

Company match is the exception, though. Even with high fees, you normally can’t beat the return on matching contributions. For example, if your company matches dollar-for-dollar, that’s an immediate 100% return.

What you can do is max out your match first — and then look to invest in another account. If you are eligible for tax-deductible IRA contributions, a no-fee traditional IRA mimics the tax perks you have in your 401(k). Your other options include the Roth IRA or taxable brokerage account.

3. You want tax diversity in retirement

Your 401(k) retirement distributions are taxable as ordinary income. Mathematically, that benefits you if you move to a lower tax bracket in retirement. Taxable 401(k) distributions work against you if you’re in a higher tax bracket as a retiree.

Numbers aside, you may feel more comfortable having taxable and tax-free income sources in your senior years. That would provide some flexibility to manage your tax bill from year to year by pulling taxable or tax-free income as needed.

You could achieve that tax diversity by making Roth contributions to your 401(k) if your plan allows it. Otherwise, you would need to look outside of your 401(k) for the solution. A Roth IRA is a good alternative if your income is within IRS limits.

4. You are eligible for HSA contributions

You are eligible for HSA contributions if you have a high-deductible health plan or HDHP. HDHPs have a deductible for individual coverage that’s $1,400 or more in 2022. The family coverage deductible must be $2,800 or more.

Like a 401(k), an HSA Is funded with pre-tax money, and earnings are tax-deferred. But unlike a 401(k), you can take tax-free withdrawals from your HSA at any time to fund qualified healthcare expenses. Once you reach age 65, you can take taxable HSA withdrawals for any purpose.

The HSA’s tax perks are more valuable than the 401(k)’s. If you are eligible for HSA contributions, it’s usually a good idea to make them even if that means lowering your 401(k) contributions.

In 2022, the IRS allows for HSA contributions up to $3,650 for individuals and $7,300 for families.

Securing your retirement

The bottom line is that it’s wise to save 10% to 15% of your income for retirement, but putting it all in your 401(k) isn’t universally appropriate. Supplementing a 401(k) with a taxable brokerage account, a traditional or Roth IRA, or an HSA may give you access to lower fees and better investments. It might also improve your tax diversity and financial flexibility.

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