It may not always be appropriate to max out your 401k contributions. That’s right, Tom and I make the case for not maxing out your 401k contributions on this week’s Mullooly Asset Management podcast. Probably not what you were expecting to hear, right? Let me preface this post by saying that most of the time, it’s a great idea to max out your retirement account contributions for the year. Your employer sponsored plan likely offers tax advantaged savings that you won’t get anywhere else. The trouble starts when individuals forget to assess their cash flow before deciding to contribute the maximum to a retirement account.
Cash flow is something everybody needs to be aware of, but it often goes overlooked in financial planning conversations. So much time and effort is spent discussing estate planning, tax advice, insurance needs and asset allocation, which are all valuable services, but the most basic topic gets lost in translation: cash flow. How much money will you have available today, this week, this month, this year? Even the best financial plans can quickly be thrown off course by forgetting to assess cash flow.
Sometimes, people with admirable intentions, like investing for their future, come on a little too strong with their 401k contributions. It’s like throwing a hail Mary on the first play of the game. It’s really awesome that people are so excited to save and invest, but in the process they bypass critical steps. I’m talking about setting aside at least 6 months expenses in an emergency fund and assessing cash flow. You want to ensure that you’ll have enough money to live comfortably and also be prepared for any unexpected events. Skipping these important steps can lead to very messy situations. Nobody ever intends to take money out of their retirement account, but it happens far more frequently than you’d think.
When somebody doesn’t have an emergency fund, unexpected events can hurt more than usual. A person with really good intentions is left with a need for cash, and the only way they’re getting it is through an early withdrawal from their retirement account. This leads to: taking a loan from a retirement account or withdrawing the money early. Early withdrawals from a retirement account are hit with a 10% penalty and, of course, state and federal taxes. Taking a loan avoids the 10% penalty, but isn’t always allowed. Loans also become taxable income. We’ve gone from a person doing the right thing by taking advantage of tax-deferred investing, to losing their own money unnecessarily in penalties and taxes. Preemptively taking money from your retirement account is a mess that can often be avoided by some basic financial planning.
The point is that investing for your future is great, but only when it’s done in an appropriate manner. Don’t blindly put as much money as possible into a retirement account because it seems like the right thing to do. Utilizing your retirement account at work is the right thing to do, after figuring out how much you can realistically afford to contribute. Assess how much money you need to live comfortably on a weekly or monthly basis. Set up bank accounts with a few months expenses and emergency money. Then figure out an appropriate amount to contribute to your 401k. We recommend being conservative with your contributions at first. You can always increase your rate later, but tapping into your retirement account early can quickly becomes a mess that costs you money. If you’ve taken all these steps and can afford to contribute the maximum to your retirement account this year, do it!