A workplace 401(k) can be a great account to invest in. But you may not want to max out the contributions you're allowed to make to it. Instead, there may be a better strategy.
Here's what it is, and why it's worth considering taking this alternative approach.
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Why you may be better off not maxing out your 401(k)
A 401(k) has a pretty high contribution limit. In 2023, you are allowed to contribute up to $22,500, and can make an additional catch-up contribution of up to $7,500 if you are 50 or over. This means you'd potentially be able to invest $30,000 in this workplace retirement plan. These contributions are made with pre-tax dollars, which means the government subsidizes the contributions you're making.
This all sounds great. But there are some possible downsides to 401(k) contributions. Specifically, you don't get to make very many choices about this plan.
Your employer sets it up, so you have to invest with the 401(k) administrator the company has chosen. You'll usually also have a pretty limited array of investment options. And if your company doesn't offer a choice between a traditional or Roth 401(k), you'll be stuck with only one option (usually the traditional account that comes with the upfront tax break).
If your 401(k) administrator charges high fees, or the limited pool of investments available to you comes with higher expense ratios, these added costs could end up taking a big bite out of the potential returns you can earn. And even if that's not the case, the fact you can't really invest in anything but a narrow range of funds in most 401(k)s means there's still an upper limit on your potential ROI.
What you should do instead of maxing out your 401(k)
Instead of maxing out your 401(k), you may be better off putting only enough in this account to take full advantage of any employer matching contributions, and then switching over to contributing to another type of tax-advantaged retirement plan.
Obviously, you always want to get your full employer match, because this is basically free money. But once you've done that, putting some of your retirement money into a traditional or Roth IRA instead of continuing to funnel it into your 401(k) could make a lot of sense because of the added available choices.
When you take this approach, you can decide if you want to contribute to a traditional IRA that works like a traditional 401(k), or if you'd prefer a Roth IRA that you invest in with after-tax dollars. A Roth gives you your tax break later, as you get to make tax-free withdrawals. If you expect to be in a higher tax bracket as a retiree, this account could be a better fit.
Both traditional and Roth IRAs can also be opened with any brokerage firm, and you can invest in just about anything, including stocks, bonds, mutual funds, and even cryptocurrencies and other alternative investments if your broker offers them. This added flexibility can be invaluable if you're a skilled investor who wants more control over how to invest your retirement money.
Now, there are income limits for deductible contributions to traditional IRAs if you or your spouse is covered by a workplace retirement plan. There are also income limits that always apply to Roth IRAs. So if you're a higher earner, these other accounts may not be an option. You may be limited to a 401(k) if you want to contribute to a tax-advantaged account since there are no upper-income limits to be eligible for deductible 401(k) contributions. In that case, maxing out your 401(k) is likely the right move if you have the money to do so.
But if that doesn't apply to you, think about first investing enough to earn your 401(k) match, then maxing out a traditional or Roth IRA. You can always go back and make additional contributions to your 401(k) if you still have money left over to save for your future after funding your IRA and reaping the benefits it offers.
