Many investors think it's responsible to max out their 401(k) contributions, but it's not the best move for some households. Tax-deferred accounts like a 401(k) or traditional IRA can be a healthy piece of a comprehensive retirement plan. However, they also have some drawbacks that people need to consider before relying too heavily on them.
What's great about your 401(k)
The 401(k) has been promoted by regulators and many financial professionals as a replacement for defined benefit pensions, which are quickly disappearing. There's no doubt that a 401(k) can be a powerful tool for saving. People can increase their savings rate by automatically withholding a portion of every paycheck. Many employers offer a contribution match, and it's important to take full advantage of these benefits when possible to improve your savings rate.
More than anything else, 401(k) contributions are popular because they are tax deferred. This reduces taxable income and can push some households into lower brackets. It also allows account holders to invest pre-tax dollars, delivering larger returns. It's plain to see the benefits that have made these accounts so popular with reputable financial professionals such as accountants, advisors, and attorneys.
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Maxing out a 401(k) isn't the best move for everyone
Every financial product has strengths and weaknesses -- there is no perfect strategy that works for everyone. Unfortunately, most Americans don't receive the proper education on the pros and cons of the 401(k) as it relates to their personal plan.
401(k) accounts have characteristics that can make some financial situations worse -- and some of those circumstances are fairly common. The two largest drawbacks of a 401(k) are the lack of functional liquidity and the embedded tax liability. These features aren't necessarily problems for everyone, but they do mean that certain households should avoid maxing out their 401(k) contributions.
Contributing to retirement accounts is a great way to save, but you're functionally locked out of funds saved into a 401(k) until age 59 1/2, or 55 in some circumstances. You can make an early withdrawal, but they are taxable, and you will incur a 10% penalty. This totally defeats the purpose of contributing those funds in many cases. Of course, there are exceptions that can waive a penalty under certain conditions, such as financial hardships and first-time homebuyer provisions. However, a 401(k) isn't a great vehicle to save for a first-time home purchase, because the time horizon on retirement investments is generally much longer than the time horizon for buying a house.
Even with these exceptions, a 401(k) offers less flexibility and access to funds than a Roth IRA or non-qualified investment account. This means that a retirement account shouldn't be maxed out until important short-term financial needs are addressed in an overall financial plan. For example, families that carry high-interest debt, such as credit card balances, should focus on eliminating that costly debt rather than maxing out a 401(k). Families that are likely to incur medical bills should consider a health savings account (HSA) if they're eligible, as HSAs offer more short-term accessibility for healthcare costs along with many of the same benefits provided by a 401(k).
It's also important to consider the embedded tax liability in qualified accounts. 401(k) contributions are tax-deferred, not tax-free. In retirement, any withdrawals will be treated as ordinary income. Most households occupy lower tax brackets in retirement than during their working careers, so it often makes sense to defer taxation.
However, this isn't always the case. People sometimes experience their lowest marginal tax rate early in their careers or during lean years in between jobs. Deferral might not be the most efficient tax strategy in those cases. Retirement plans also need to consider the possibility that tax rates are much higher two or three decades down the road. In that case, it could be a costly mistake to trade today's rates for tomorrow's. Investors can diversify their tax exposure by combining a 401(k) with non-qualified accounts, such as a Roth IRA or regular brokerage account.
Ultimately, retirement accounts are an important piece of an overall financial plan. A 401(k) has to work in harmony with all of your financial strategies and products. Some households can optimize their outcomes by maxing out 401(k) contributions. Others need to allocate dollars elsewhere. Before you decide to max out your 401(k) contributions, consider the pros and cons of these accounts in the context of your personal circumstances.
