Can Contributing to Your 401(k) Be a Bad Idea?

Conventional wisdom says that you should always contribute to your 401(k), no matter how young you are. For the most part, it's great advice: Retirement plans offer a tax-advantaged way to grow your nest egg; employer-matched contributions are basically free money for your golden years; and the earlier you pay into the account, the longer your money will have to grow.

With all those advantages, you should start saving for retirement as soon as you start working - unless you have a good excuse. The question isn't so much whether you should be saving for retirement, but whether you have a good reason not to save.

When you should definitely not contribute to a 401(k)

Can you cover the minimum payment on your debts?

If you're struggling to make ends meet, contributing to a 401(k) or IRA is pretty much out of the question. Instead, focus on ways to lower your expenses or increase your income, such as:

  • Taking a freelance job or renting unused rooms, parking spots or cars
  • Refinancing high-interest debts
  • Looking into tax credits or student loan deferments, if applicable

Investing in your retirement is a good financial move, but you don't want to hamstring your current financial situation.

Do you have an emergency fund?

Once you’ve reached financial stability with your debts, you should make sure that you have enough money set by to weather three to six months of unemployment. This emergency fund protects you against unexpected layoffs, unforeseen medical expenses, or even hostile work environments. Keep your emergency fund in easily accessible assets, like a high-yield checking or money market account, rather than in stocks or bonds. That way, it’ll be there when you need it, and won’t evaporate if there’s a market downturn.

When you're deciding how much to put into your emergency fund, keep in mind both your current cost of living, and how much you can reduce that cost. A San Franciscan with two kids and a mortgage will need a larger emergency fund than a young, single person in Albuquerque who doesn't mind moving in with his parents.

Contributing to your 401(k) is a very good thing, but mitigating the effects of an unexpected layoff or health scare is a higher financial priority.

Further reading: Emergency Fund Basics: When, Where, and How Much?

Do you have an “idiot fund”?

Once you’re protected against layoffs or other major crises, you’ll want to protect against, well, yourself. Ever had one of those embarrassing (and costly) “I’m an idiot” moments like dropping your phone in the toilet or getting a parking ticket? Those are the moments that call for an idiot fund.

Similar from your emergency fund, this is a smaller ($2,000-5,000) amount set in reserve to cover unanticipated expenses like broken laptops or needing to replace a lock. If you need to draw on this fund, top it off again when you have money to spare. Not only does this provide a psychological safety net, but you're better able to avoid costs like auto repairs that impact your ability to work. An idiot fund guards against “unexpected” expenses that, in reality, are all too common.

Have you paid off your high-interest debts?

If you're paying double-digit interest on credit cards or other loans, pay those off first. Think of it this way: if you "invest" in paying off a 15% APR credit card, you're essentially getting a guaranteed 15% return on your investment. You can't get that in the stock market! If you have any debts with an interest rate above a decent annual return on an investment portfolio (7% is a good benchmark), paying those debts should be your first priority.

Further reading: Should I Contribute to My 401(k) or Pay Off Debt?

Caveat: Employer match

The one caveat here is that you may want to consider setting aside some money, even if the scenarios above apply to you, if your employer offers a 401(k) match. Even if you have a few other competing financial priorities, if your employer offers a generous match, then not contributing money to get at least some of the match means you're turning away free, pre-tax money that can build compound interest over time. If, for example, your company has a 3% match, even contributing 1% to get a 1% "bonus" in free money is still worthwhile.

Here are a few other, less hard-and-fast priorities that you might have in mind.

When 401(k)’s may or may not be the best place for your money

You're saving up for a home

Other major money goals like homeownership are a little trickier. Contributing to a 401(k) is a good idea in this scenario - especially if you’re getting a 401(k) match from your employer - but depending on how much you want to save, how quickly you’ll need the money, and your current account balance, you can definitely make a case for de-prioritizing retirement savings.

You have lower-interest debts

Paying off a lower-interest debt, like a subsidized student loan or mortgage, offers another dilemma. Obviously, you should make your minimum payments on those loans, but past that, how do you weigh getting out of those debts against saving for retirement?

Here’s one way to think through the situation: Assume that your retirement account will grow at 4% a year (it never hurts to be conservative). Is that 4% higher than the interest rate on your other loans? If so, contribute. If not, pay off your debts. The scale tilts in favor of retirement accounts if you're getting a match from your employer. This calculation doesn't factor in tax savings for 401(k)'s and IRA's, but it's a solid rule of thumb.

Contributing to your kids' education

If you plan to spend on higher education, whether your family’s or your own, a tax-advantaged 529 account is one of the best ways to save up. Contributing to a 529 or a 401(k) pretty much comes down to your priorities. You want your kids to have a good education, but you also don't want to be a burden on them if you retire with too little money.

One way to weigh these options is to calculate how much you plan to contribute to your child’s tuition and education expenses, then work backward into how much you need to put into a 529 to reach that goal. For example, let’s say you want to contribute $40,000 to your child’s tuition 18 years from now, and keep the conservative 4% annual growth rate assumption. You’ll need to contribute about $185 every month to meet that goal. (You can run the calculations for yourself here). Based on that, you should kick in $185 to your 529, and put the rest into your 401(k).

One caveat: If you're thinking of contributing to your own 529 because, say, you want to go to graduate school in three years, you should prioritize 401(k) contributions instead of 529. 529 contributions come from taxed income, and only the growth is tax-free,. Over a two- to three-year timeframe, the gains just aren’t worth the extra taxes (especially if you’re getting an employer match).

Deciding how much to save for retirement isn’t as easy as putting in as much as you can save up to annual limits - you have to establish a level of financial security first, then weigh retirement against other financial priorities like owning a home or paying tuition. That said, you should definitely make saving for retirement a priority, no matter how old or young you are.

How much should you save for retirement?

Once you’ve met your financial obligations and priorities, how much money should you contribute to your retirement funds in general? Many experts suggest that you budget 10% of your post-tax income to retirement. If you’re in your twenties, though, that figure may be wildly optimistic given that people live longer and increasing tax rates are not inconceivable. Contributing 15-20% post-tax is a much better figure - and that's a floor, not a ceiling. If you're lucky enough to have 25% of your paycheck left over after expenses, don't be shy about putting it into retirement savings (up to the contribution limits, of course).

The reality is that retirement is less certain for millennials and 30-somethings than previous generations who could count on pensions and a strong safety net. Who knows where Medicare and Social Security - let alone tax rates - will be in 2050? Many personal finance draw from rules of thumb made in different times, so it's in your best interest to save more than conventional wisdom dictates.

Want your employer to offer a 401(k)?

401(k)s offer a way to save even more for retirement, on top of your IRA contributions - and employer matches can be better than bonuses from a tax perspective. Send your HR team or company owner this guide on the cost savings of 401(k)s to get the ball rolling.

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