The Unfortunate Truth About Maxing Out Your 401(k)

The Unfortunate Truth About Maxing Out Your 401(k)

Maxing out your 401(k) may seem like a no-brainer for your financial bucket list. If you maxed out your 401(k) consistently for a couple of decades, you could easily retire a millionaire.

A 401(k) is a great wealth-building tool. But if you’re thinking of pushing your contribution to the limit, you may want to reconsider. Read on to learn about the downsides of maxing out your 401(k).

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The real cost of maxing out your 401(k)

The 401(k) tax benefits are undeniable. If your employer matches part of your contribution, that’s free money. And contributing to a 401(k) is probably the easiest way to start investing. So none of this is intended to say you shouldn’t invest in your 401(k).

A 401(k) offers fairly high contribution limits. In 2022, the maximum contribution is $20,500, or $27,000 if you’re 50 or older. Those limits will rise to $22,500, or $30,000 for people 50 and up in 2023.

But if you’re not a six-figure earner, maxing out your 401(k) may not be realistic. There’s also a risk in putting a huge percentage of your salary into a retirement account, particularly if you don’t have much other savings.

Because of early withdrawal penalties, 401(k) investments generally aren’t considered liquid until you reach age 59 1/2. Plus, it’s risky to have any money you may need within a few years invested in the stock market due to its short-term volatility.

Consistently investing for retirement is essential, of course. But there are a lot of things you’ll need to save money for between now and your retirement. For example, diverting a large percentage of your income to your 401(k) could make it harder to hit other goals, like buying a house, saving for your child’s college, or paying off high-interest debt.

What’s a good 401(k) savings goal?

Even if you can afford to invest more than $20,000 a year for retirement, your 401(k) may not be the best place for all that money. Typically, the investment options are limited and the fees are higher than you’d pay if you opened an individual retirement account (IRA) through a brokerage.

In financial planning, the gold standard is to aim for saving about 15% of your pre-tax income for retirement. That includes employer contributions. If you’re getting a late start on saving for retirement or you’re planning to retire early, you may need to aim a bit higher.

But that doesn’t mean all of that money needs to go into your 401(k). Always take advantage of any employer match since it’s free money. Beyond that, consider all your options before you throw all that money into unmatched 401(k) contributions.

What are the best 401(k) alternatives?

Once you’ve gotten your full match, you may then want to max out a Roth IRA, since you’ll have more investment options. Plus, because a Roth IRA is funded with after-tax dollars, you get unlimited tax-free growth, and you can access your contributions at any time.

In 2022, you can contribute up to $6,000 to a Roth IRA or a traditional IRA. The contribution limit will increase to $6,500 in 2023. People 50 and older can contribute an additional $1,000 in both 2022 and 2023.

If you have kids and you plan to pay for some of their education, you could invest some of the extra money in a 529 plan. A health savings account (HSA) can also be an effective investment vehicle. If you don’t need the money for healthcare, you can withdraw it penalty-free for any reason once you’re 65.

Finally, a taxable brokerage account could be a better option for your investment dollars if you want flexibility. You won’t get any tax breaks, but you can access your money without penalty at any time.

When should you max out your 401(k)?

Maxing out your 401(k) can be a smart move in some circumstances. If you have a high income, you may want to max out every tax-advantaged account available. You may also need to double down on retirement savings if you’re behind your goal.

But your personal situation should guide how much you put in your 401(k). Saving for retirement isn’t your only financial goal. If you have shorter-term goals, think carefully before maxing out your 401(k).

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