By Dave Rowan
Learn more about Dave on NerdWallet’s Ask an Advisor
“Should I max out my 401(k)?” This question is often answered quickly, with a simple, “Yes! Defer taxes for as long as you can.”
To help answer the question, here are two “givens” that are true for everybody:
Given #1: Fill up your emergency fund first
Before even thinking about retirement savings, pad your emergency fund. I recommend having at least six months of living expenses set aside in a separate bank account for times when life throws you the inevitable financial curveball.
Given #2: Grab the company match second
Once you’re set for emergencies, make sure you’re contributing at least as much to your 401(k) as your company is willing to give you in matching contributions. For example, if your employer matches up to 6% of your salary, put away at least the full 6%. That match is free money!
After that, things get more complicated. Ask yourself these questions to decide how much additional money you should contribute to your 401(k) — and how much you should contribute to other accounts:
How much do I need for retirement?
In general, the earlier you get started, the less you need to save for retirement. Let’s say you’re in your 20s and have determined you need to save 12% every year to meet your retirement goals. If your company matches 6%, you can contribute 6%, score the 6% match, and might not need to make any further contributions. You can put extra money toward a down payment on a house or your kids’ college tuition.
» Is your money working for you? Use NerdWallet’s free retirement planning tool to learn how to get your retirement on track.
You can meet your retirement goals if you start later, but it means you’ll have to make a much larger 401(k) contribution. For example, if you are in your late 30s and you decide you need to save a greater amount, you could contribute the maximum $18,000 to your 401(k) and quickly build retirement savings. But starting earlier, with smaller investments, is more manageable.
» MORE: Try our 401(k) calculator
After you’ve snagged the free money your employer offers, there are also good reasons to direct some of your retirement savings toward a Roth IRA — whether or not you need to make additional contributions. Unlike 401(k) contributions, Roth IRA contributions are post-tax. They then grow tax-free, along with their earnings, and you won’t pay additional taxes on them when you withdraw them in retirement. Their features can benefit savers for three reasons:
1) Having your savings split between tax-deferred and tax-free accounts gives you maximum “tax flexibility” in retirement. There’s no single right answer for everyone, but as a general rule, consider having 60% to 80% of your savings in tax-deferred accounts, such as your 401(k), and 20% to 40% in tax-free accounts, such as a Roth IRA.
2) Many 401(k) plans have limited investment choices and high fees. But if you have a Roth IRA, you can either invest it yourself or work with a financial advisor to construct a well-diversified portfolio of low-cost ETFs. Roth IRAs give you more control over your investments and their costs, letting more of your hard-earned money grow on your behalf in your account.
3) Roths are an especially good idea if you’re in a relatively low tax bracket now. It probably makes sense for you to pay taxes in this lower bracket by contributing to a Roth IRA, rather than saving all of your money in your tax-deferred 401(k), only to end up paying at a higher rate in retirement.
Now, one final question before you make a call on how much to tuck away into that 401(k):
How much money do you make?
If you’re single with a modified adjusted gross income in excess of $132,000 or married with a MAGI of more than $194,000, you’re not allowed to contribute to a Roth IRA. In this instance, it probably does make sense to max out your 401(k).
If you’re still looking to shield additional income from taxes, you can consider investment real estate and certain life insurance products, but we’ll leave that discussion for another day.
Good luck working your way through your decision on how much to contribute to your 401(k) and with all of your retirement and savings goals!
This article also appears on Nasdaq.