Common 401(k) tips savers should take with a grain of salt


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

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

1. You are aiming for early retirement

The 401(k) withdrawal rules are for those retiring in their late 50s or early 60s. Normally, any 401(k) distributions you receive before age 59.5 are subject to a 10% early withdrawal penalty. There is an exception for workers who leave their job at age 55 or older.

But if you retire before age 55, you are subject to the 10% penalty on withdrawals up to age 59.5. Unless you wanted to take the 10% hit, you would need hidden assets outside of your 401(k) to temporarily pay the bills.

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

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

2. Your 401(k) is poor

Some 401(k)s have high administrative fees that reduce your returns. Others have marginal or high-fee investment options that underperform 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.

The corporate match is the exception, however. Even with high fees, you normally can’t beat the performance of matching contributions. For example, if your business 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 traditional no-fee IRA mimics the tax benefits you have in your 401(k). Your other options include the Roth IRA or a taxable brokerage account.

3. You want a diversified tax system in retirement

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

Numbers aside, you might feel more comfortable having taxable and non-taxable sources of income during your retirement years. This would provide some flexibility to manage your tax bill from year to year by drawing taxable or non-taxable income as needed.

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

4. You are eligible for HSA dues

You are eligible for HSA dues if you have a high deductible or HDHP health plan. HDHPs have a single coverage deductible of $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 the earnings are tax-deferred. But unlike a 401(k), you can withdraw tax-free withdrawals from your HSA at any time to fund eligible healthcare expenses. Once you reach age 65, you can take taxable HSA withdrawals for any purpose.

The tax advantages of the HSA are more valuable than those of the 401(k). If you’re eligible for HSA contributions, it’s generally a good idea to make them even if it means reducing your 401(k) contributions.

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

Securing your retirement

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

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