While the benefits of maxing out your 401(k) are well documented, there still exists a few inconvenient downsides when you invest in your employer's retirement plan. Even though the upside is likely to outweigh the downside when it comes to planning for retirement, you should be aware that the 401(k) isn't a complete problem-solver as far as your total financial picture is concerned.
Let's review a few of the downsides as it relates to maxing out your 401(k).
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The potential for taxes and penalties
If you look at life like a math problem, it's fairly easy to see that contributing the maximum to your 401(k) over a 30- or 40-year working career makes a lot of sense. If you contributed the current maximum to your 401(k) plan (currently $20,500; $27,000 if you're over 50) from the ages of 22 through 50, you'd end up with $1.95 million, assuming an 8% investment return.
The reality, however, is that life isn't a math problem. We need money now for all sorts of different scenarios, both expected and unexpected.
Should you need to withdraw from your 401(k) plan before age 59 1/2 and your employer allows you to do so, you'll be hit with both ordinary income tax and a 10% penalty. Depending on your tax bracket, as well as your state of residence, taxes and penalties on an early 401(k) withdrawal can total 50% or higher.
The dual threat of taxes and penalties can make a full commitment to your 401(k) impractical if you need the money for immediate use.
Investment options might be limited
Many legacy 401(k) plans are known for their high fees and suboptimal investment choices. While this certainly isn't the case for all 401(k) plans, there are plans in the 401(k) universe that offer mutual funds with expense ratios of 1% or higher, along with administrative fees near the same amount. For reference, most basic index mutual funds can be had for 0.05% or less at most of the discount brokerages.
On a related note, when you fully max out your 401(k) for the year, you commit to the investment menu provided by your employer. You likely won't have access to the entire selection of investment choices you would have elsewhere, and probably won't be able to buy single stocks, bonds, options, or even ETFs. If these investments are important to you, your 401(k) isn't the best place to go.
You may have more pressing needs
If you have other immediate needs, like high-interest debt, unpaid taxes, or any other short-term financial priority, maxing your 401(k) is probably not the best idea.
Clearing out financial anchors like rapidly growing debt is a smart call before going head-first into your company's 401(k) plan. While saving for retirement shouldn't be delayed, you don't need to feel pressure to hit the maximum every year if you have other financial demands -- or even an underfunded emergency fund.
A potential solution here is to contribute up to your employer match percentage and then hold off on maxing 401(k) contributions until you have excess money available. This allows you to take advantage of "free money" in the form of the employer match, while also enabling you to address near-term needs that improve your total financial standing.
Your 401(k) isn't everything
Of course, a 401(k) is a valuable retirement planning vehicle, and most people should seriously consider taking advantage of their employer's offering. However, to say that everyone should always maximize their 401(k) contributions for the year isn't accurate.
Before maximizing your 401(k), you'll need to do a comprehensive evaluation of your total financial picture. Primarily, think about how much cash you can afford to part with in the short term; that amount can be dedicated to current 401(k) contributions. Excess money can be used to build a cash reserve or pay down nagging debt.
No matter your course of action, always consider your options and their associated consequences before making a final decision around how much to contribute to your 401(k).
