Maxing out your 401(k) is standard financial advice touted by many advisors, but it may not always be the best option.
A 401(k) is an employer-sponsored plan that allows you to save either pre-tax or post-tax contributions in a retirement account. Employers are also required to make matching contributions to the plan. If you choose to make pre-tax contributions, you realize an immediate tax saving or if you max a post-tax contribution, you’ll let those funds grow and be able to access them tax-free in retirement.
But a 401(k) is not the best option if you think you’ll need access to your savings before retirement since the funds are locked away and usually expensive to access before you turn 59.5 when they’re in a 401(k). There are some circumstances where you can access the funds before that age without paying the 10% federal penalty.
Benefit of Maxing Out Your 401(k)
The maximum amount you can contribute to your 401(k) changes each year. For 2023, you can contribute up to $22,500 (or $30,000 if you are 50 or older). These contributions can either be made to a pre-tax or post-tax account, but the combined pre- and post-tax contributions cannot exceed these limits.
Note that starting in 2026, the catchup contribution for people 50 or older must be contributed to a ROTH 401(k) account.
The main benefit of pre-tax contributions is the immediate reduction of your taxable income. For a taxpayer over age 50 who is currently in the 24% federal tax bracket and maxes out their 401(k), they would save $7,200 ($30,000 * 24%). If you live in a state that charges state income taxes, the immediate savings will increase.
Once the funds are in your 401(k), the money will grow tax-free until you take distributions from the account. Currently, you are not required to start taking required minimum distributions (RMDs) until age 73. If you’re still actively working at age 73, some plans allow you to further delay distributions from the account.
You usually don’t have to max out your contribution to get the maximum employer contribution, but you should make sure that you’re contributing at least enough to maximize your employer match. This is essentially free money that you are giving up if you do not contribute enough to get the full match.
Consider an employer that offers to match the first 3% of your salary that you contribute and 50% of the next 3%. So if you contribute 6% of your salary, your employer would contribute an additional 4.5% which is an immediate return of 75% on your investment.
Note that employer contributions are usually vested over several years. If you leave your job before the contributions are fully vested, you’ll lose out on any non-vested contributions.
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Considerations Before Maxing Out
But before you max out your 401(k) for immediate tax savings, there are a few things to consider.
Though saving for retirement is important, you should consider your immediate need for liquidity before locking your funds away. Once you’ve put money into a pre-tax 401(k), you won’t be able to withdraw funds from the account without paying income taxes plus penalties on the withdrawals. The federal penalty for early withdrawal from a 401(k) is 10%. Many states also have additional penalties on early withdrawals.
If you have an upcoming large expense or investment opportunity, it may not be the time to max out your contributions.
Most 401(k) plans have the option of taking a loan against your balance, but the loan is limited to $50,000 or 50% of your balance. Any interest you pay on the loan is credited to your account. There are also limits on the number of outstanding loans you can have at one time. These rules are determined by your plan.
When you’re thinking about your investments, you need to consider all of your accounts. Diversification happens across your entire portfolio – both retirement and non-retirement accounts.
Many retirement accounts offer limited investment options. For employer-sponsored plans, you’ll have to pick from a list of pre-approved investments selected by your employer. These investments may or may not align with your overall investment strategy.
If the funds offered by your employer do not fit your plans, it might make sense to contribute enough to get your employer match, but then make your investments in other accounts.
Future Tax Rates
If you are currently in a low tax bracket, you may want to reconsider maxing out your contribution or consider making Roth contributions to your 401(k).
Consider a single intern making $60,000 a year. This taxpayer would be in the 22% tax bracket. If the intern maxes out their 401(k) by contributing $22,500, they’ll drop down to the 12% tax bracket. Given a standard physician’s career, taking into account investment earnings and RMDs in retirement, they will likely end up in a higher tax bracket in retirement. In this case, it’s less tax-efficient to make pre-tax contributions while in a low bracket.
Even given similar pre- and post-retirement incomes, it’s possible that future tax laws will change and increase tax rates (although it’s hard to predict what changes will happen).
Other Financial Goals
When considering maxing out your 401(k), you need to think about your other financial goals. While a well-funded retirement is important, you may have more pressing needs for your funds.
Buying a home, paying off high-interest student loans, managing credit card debt, or putting a kid through college may take priority. Because of the expense of accessing your 401(k) discussed above, you should carefully consider whether you have the means to max out your contributions without sacrificing your other goals.
Alternatives to Maxing Out a 401(k)
If you’ve decided that maxing out your 401(k) isn’t right for you, you should consider these alternative moves.
If your income is low and your employer doesn’t offer a Roth 401(k), you should look at a Roth IRA. For 2023, you can contribute to a Roth IRA if your income is below $153,000 for single taxpayers or $228,000 for couples filing jointly.
Roth IRAs allow you to make post-tax contributions to your account and take the contributions out tax-free in retirement. Contributions are limited to $6,500 per person (or $7,500 if 50 or older).
Having a combination of pre-tax and post-tax accounts can help you manage your taxes during retirement by giving you options for where to take distributions beyond your RMDs.
Health Savings Accounts (HSAs)
HSAs are considered ideal options for increasing your retirement savings. You put pre-tax money into the account, and you can do this even if you’ve already maxed out your 401(k) contribution for the year. The money grows tax-free, and you can access the funds at any time to pay for medical expenses. Any distributions from the account for medical expenses are tax-free.
To be eligible to contribute to an HSA, you must have a qualifying, high-deductible medical plan.
Single taxpayers can contribute $3,850 in 2023 while married taxpayers can contribute $7,750. If you are over age 55, you can make an additional $1,000 catchup contribution.
Real Estate and Other Investments
If you are considering getting into real estate investing, maxing out your 401(k) will limit the funds you have available for a downpayment. Most 401(k)s do not allow alternative investments such as real estate although some individual 401(k)s will allow you to hold alternative investments.
If you want to hold non-traditional retirement assets such as real estate or partnership interest in your 401(k), you’ll need to work with a company that specializes in these types of arrangements.
Factors to Consider When Deciding
When deciding what your best move is, you should take into account the following factors.
Age and Retirement Horizon
Younger individuals have the advantage of significant growth over time which increases the impact of early tax savings. However, younger people are more likely to be in a lower tax bracket. You’ll need to consider your time horizon, current tax situation, and future expected retirement.
Older individuals can benefit from making additional catch-up contributions, but the contributions will have less time to grow. Older individuals are more likely to be in a higher tax bracket if they’re in their peak earning years so pre-tax contributions will have more of an impact.
Current Financial Situation
If you have high-interest debt, you should consider paying off your debt prior to maxing out your retirement contribution. High-interest debts, like credit card debts, should be prioritized for repayment. It’s often more beneficial to pay off these debts before aggressively investing.
You should also realistically look at your current income and expenses to determine if it’s feasible to increase your retirement contributions.
This review of your financial situation should also include a calculation of how much you expect to need in retirement savings before you retire.
It’s essential to understand how comfortable you are with the idea of your investments fluctuating in value. Some people are more risk-averse and prefer stable investments, while others are willing to take on more risk for potentially higher returns.
You’ll want to evaluate your 401(k) investment options to determine if they align with your long-term goals. If the options don’t align with your goals, then you may not want to max out your 401(k).
Final Thoughts on Maxing Out Your 401(k)
Maxing out your 401(k) or any retirement account is a commendable goal, but it’s essential to approach this decision with a comprehensive understanding of your financial situation. There’s no one-size-fits-all answer to whether it’s the right move. You should consider your goals, current finances, and current (and future) tax expectations before maxing out your contributions. Remember that once you’ve made the contributions, future withdrawals (before age 59.5) you have limited options for how much and when you can access the funds without paying the 10% federal penalty. Making sure that you have accessible savings in a bank or investment account, can minimize the chances that you need to take early withdrawals from your 401(k).