Maxing out your 401(k) may seem like a no-brainer move. But it's also a tough goal for a typical worker to achieve. In 2023, you'd need to contribute $22,500 to max out your 401(k) if you're younger than 50. If you're 50 or older, you'd need to kick in an extra $7,500 catch-up contribution -- $30,000 total -- to reach the limit.
Maybe you can easily afford to max out your 401(k). Or maybe contributing these amounts would put a serious strain on your budget. Either way, maxing out your 401(k) isn't always the best option for your money. Here's what you need to consider.
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The high cost of maxing out a 401(k)
A 401(k) can lower your tax bill -- either for the current year if you choose a traditional 401(k) or when you retire if you opt for a Roth 401(k). Often, it comes with free money since most employers match a portion of employee contributions.
But when you contribute to a 401(k), your money is effectively locked up until you reach age 59 1/2 or age 55 if you leave your job unless you're willing to pay a penalty. Though you can typically withdraw your money early, you'll typically pay a 10% early withdrawal fee on top of taxes for an early distribution.
That's on top of the risk that you face with any investment, which is that the value could drop, particularly in the short term. If all your money is stashed in a 401(k) and you experience an emergency during a bear market, you could have to sell investments when they're down while also incurring taxes and penalties.
Consider the alternatives to a 401(k)
Taking advantage of your employer's 401(k) match just about always makes sense unless contributing would put you behind on bills or cause you to take on debt. But once you've secured your company match, consider the alternatives for saving an investing your money before you max out your 401(k). Some alternatives to consider:
- Emergency fund: Before you make 401(k) contributions above your employer's match, consider saving a six-month emergency fund first. This provides a buffer so you won't have to raid your retirement if you lose your job or get hit with an unexpected expense.
- Roth IRA: Prioritizing Roth IRA contributions after you've scored your employer match is a smart move for many investors. You'll forgo an upfront tax break, but you'll get unlimited tax-free growth and retirement withdrawals. Plus, a Roth IRA has several flexible features that a 401(k) doesn't offer. For example, you can withdraw your contributions (but not your earnings) any time with no taxes or penalties.
- 529 plan: If you have children, you may want to use some of your investment budget to invest in a 529 plan for their education.
- Taxable investment account: Because investing is so key to funding your retirement, it's easy to forget that your investments can be used to fund other financial goals. If you're hoping to cash out on investments in the medium term (think several years from now), a taxable brokerage account is a good way to go if you're not close to retirement age.
- Savings account: If you'll need money for a major expense in the next year or two, you might want to put extra money in a savings account instead of your 401(k). You typically don't want money in the stock market that you're counting on for short-term needs.
Should you max out your 401(k)?
Investing for your retirement is essential. Financial planners typically recommend socking away at least 15% of pre-tax income in a retirement account. If you're getting a late start, you should aim even higher.
But maxing out your 401(k) isn't always the best move. Again, scoring your employer's full match will make sense for the vast majority of people. If your employer offers a 50% match, you're scoring 50% returns off the bat.
But beyond that, think carefully about where you want to put extra money. 401(k)s typically have limited investment options and higher fees compared with individual retirement accounts (IRAs). You may also want to put extra money toward non-retirement goals.
Maxing out your 401(k) can be a smart move if you have no high-interest debt, your emergency fund is solid, and you're looking for a tax-advantaged way to invest your extra dollars. But your contributions should be guided by your personal circumstances and goals rather than the IRS-imposed limit for any given year.
