Should you max out your 401(k), or not?

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Here’s this month’s New Jersey personal finance question: Should I max out my 401(k)?

Under the New Jersey Small Business Retirement Marketplace Act, employers with 25 or more employees are required to provide retirement savings plans for their employees. If you are an NJ resident, you may be wondering if it makes sense to max out your 401(k) or use other vehicles.

What is a 401(k) plan?

A 401(k) plan is a profit-sharing plan offered by your company, allowing you to contribute to an account in your name on a pre-tax basis. If your employer offers a Roth 401(k) option, you may also be able to contribute on an after-tax basis. In both cases, you contribute a portion of your salary periodically such as weekly, bi-weekly, or monthly. Once funds have been contributed to your account, you can invest by selecting from the investment options made available to you. In some cases, your employer may contribute on your behalf or match your contributions, up to a certain percentage, in addition to your own contributions.

Other things you should know about 401(k) plans:

Traditional 401(k)

  • Realized capital gains, dividends, and interest are tax-deferred
  • Distributions are taxable as ordinary income (may be subject to penalties if not qualified)

Roth 401(k)

  • Realized capital gains, dividends, and interest are tax-deferred
  • Distributions are tax-free (may be subject to tax and/or penalties if not qualified)
  • Subject to income and contribution limitations
  • The employee contribution limit for 2024 is $23,000 (Traditional and Roth 401(k) combined)
  • Additional “catch-up” contributions for those age 50 and above may apply

Consider other options before maxing out your 401(k) plan

Before maxing out your 401(k) contributions, consider other investment account types that may be available. You may be missing opportunities to utilize accounts that are set up to allow for greater flexibility both now and when you take distributions from your accounts down the road. Here are a few account types that are very popular among investors seeking financial independence.

Traditional IRA

An individual account with similar attributes to a Traditional 401(k), from a tax perspective. However, unlike a 401(k), you have more flexibility as to how you invest your funds and qualified distributions are subject to different requirements.

  • Contribute pre-tax dollars
  • Realized capital gains, dividends, and interest are tax-deferred
  • Distributions are taxable as ordinary income (may be subject to penalties if not qualified)
  • Subject to income and contribution limitations
  • The contribution limit for 2024 is $7,000 (Traditional and Roth IRA combined)
  • Additional “catch-up” contributions for those age 50 and above may apply

Roth IRA

An individual account with similar attributes to a Roth 401(k), from a tax perspective. However, unlike a 401(k), you have more flexibility as to how you invest your funds and qualified distributions are subject to different requirements.

  • Realized capital gains, dividends, and interest are tax-deferred
  • Distributions are tax-free (may be subject to tax and/or penalties if not qualified)
  • Subject to income and contribution limitations
  • The contribution limit for 2024 is $7,000 (Traditional and Roth IRA combined)
  • Additional “catch-up” contributions for those age 50 and above may apply

Brokerage account

An individual account that offers the most flexibility in many cases, as you have a wide range of investment options and no income or contribution limits. However, you don’t receive the favorable tax treatment like you do in a 401(k) or IRA.

  • Contribute after-tax dollars
  • Realized capital gains, dividends, and interest are taxable in the year realized/received
  • Distributions are tax-free
  • Not subject to income and contribution limitations

Bottom line: what’s best for me?

There is no magic formula to determine whether maxing out your 401(k) plan is the best decision for you and your financial plan. However, we all know lifestyle and retirement expectations tend to change over time and therefore you should consider diversifying your account types to allow for greater flexibility both today and in retirement.

Are you interested in learning more about how you may be able to make use of these accounts? If so, send me a message to discuss.

-Shaun

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