Ask Money

Put the max into the 401(k)

Chris Farrell Mar 14, 2011

Question: I’m 29 years old, earning 100k+ a year and have no debt. I do not yet own a home. Up until now I have only been contributing 6% to my 401k to receive the maximum company match. That comes to about 6k of my money.

My question should I be maxing out my 401k to the 16,500 limit or should I invest the remaining 10k in other investments? What is the advantage other than tax deferral and compound interest, of putting the maximum in the 401k at this point? And are those two benefits relevant to my situation? Thank you in advance for your thoughts on this. Ryan, San Jose, CA

Answer: It’s great that your saving in the 401(k) and that you want to do more. There is a very simple takeaway no matter what you end up deciding to do with your 401(k): Increase the amount you’re saving.

Now, it’s good that you’re taking full advantage of the company match in your 401(k). The match is where much of the gain in a 401(k) comes from over the years.

I wouldn’t underestimate the power of compound interest. It’s what Albert Einstein called the “most powerful force in the universe.” Compound interest is a major reason why I favor putting the maximum into the 401(k). What’s more, the investment money automatically comes out of every paycheck and the tax-deferral makes it easier to save.

The earlier you can set aside the maximum the more you’ll have 40 years from now. of course, this assumes your company offers you low-fee well-managed mutual fund choices in the 401(k).

That said, what might be an alternative? You could establish a Roth-IRA in addition to your 401(k) contributions. In 2011 you can make a full contribution to the retirement savings plan–$5,000 for individuals–with an income of up to $107,000. (The Roth contribution limits phases out from $107,001 to $122,000 in 2011.) A Roth is funded with after-tax dollars. The earnings are tax-free when withdrawn in retirement.

If you do set-up a Roth I helps to make the contributions automatic.

You don’t mention it, but I hope you are putting money into an emergency savings fund. If not, I would slightly increase how much is going into the 401(k) and definitely hike the sum going into emergency savings. You can always shift the amounts or ratios going into retirement savings and emergency savings later on.

Taken altogether, I think a good goal is saving in your tax-deferred and taxable accounts somewhere between 15% and 20% of income. It will probably take you time to get there, but it’s a goal worth steadily working toward.

One last point: I’m not sure what you meant by “other investments”? It can be a savvy move to invest some money in low-cost broad-based mutual funds held in a taxable account or a Roth. But I would be wary if it means getting into the stock picking game.

Investing in individual stocks is fun, but with this caveat: The money you invest should be your “play” money or “mad” money. In other words, its money you can afford to lose. I wouldn’t put your standard of living in retirement at risk to your stock-picking prowess.

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