Maxing out your 401(k) every year has its advantages. You'll benefit from heavy tax deferrals, high contribution limits, and (in many cases) an employer match. Also, contributions are done via automatic payroll deductions, so you don't even feel like you're contributing every week or two.
However, there are some downsides to maxing out your 401(k) every year. Here, we'll discuss the unfortunate truth about doing so.
Your 401(k) carries a tax liability
Anytime you contribute money to your pre-tax 401(k), you effectively trade a tax bill in the present for a tax bill at some point in the future. The implicit bet is that you hope to pay a lower tax rate in retirement than you did while working -- which, for a majority of people, is likely to be the case. Thus, when you go to withdraw the money in retirement, you'll pay less tax than you would have if you took the money when you earned it.
This can create an interesting problem for retirees. If your 401(k) is worth $100,000, you should know that the entire balance is, in fact, not really all yours.
Some percentage of that money will ultimately be paid to Uncle Sam (and your state taxing authority, if applicable) as soon as you take money out of your account. The actual rate you'll pay has to do with a variety of factors, particularly how much other money you earn during the year, as well as your state and city of residence.
So while you'll still benefit from tax-deferred growth in a maxed-out 401(k), you're also leaving yourself open to a possible headache around tax management after you retire.
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You'll be penalized if you withdraw early
Devoting the annual maximum to your 401(k), by default, means less money for other opportunities. This could mean less money available for a potential down payment on a home, or it could mean less money to invest in a taxable brokerage account. Keeping money at the ready in 401(k) alternatives might be a smart idea if you'll need the funds in the near future, especially because you'll be taxed and penalized if you withdraw from your 401(k) before age 59 1/2 in most cases.
The penalty for early withdrawal is 10% of the amount taken out. This is in addition to any federal, state, and local taxes you'll owe come tax time. So it's extremely important that you fund your 401(k) only with what you know you won't need for other, more immediate purposes or for other retirement accounts.
You're limited in your investment choices
Most people are fine with having a predetermined menu of mutual funds for their retirement money. The grand majority of 401(k) plans (if not all) offer you a list of mutual funds, most of which are perfectly adequate for the long run. But depending on your specific goals and risk tolerance, this investment choice might not be enough for you.
Maxing out your 401(k) while leaving little to invest elsewhere lmeans that you'll potentially miss out on investing in stocks, bonds, options, or other, more esoteric investments like cryptocurrency. Whether these choices are worth missing is up to you, but you'll probably be limited in your investment choices if you devote too much to your 401(k).
Some plans offer unnecessarily expensive mutual funds and/or levy redundant fees. This is another big reason to understand the fees of your company's 401(k) plan before devoting too much of your hard-earned cash to it.
Get to know your 401(k) plan
Maxed-out 401(k) plans can be valuable assets in retirement. But it's also key to know how your plan functions and what opportunity costs come with a maximum annual investment.
If you're unsure about how much to contribute, consider devoting at least enough to maximize your company's matching percentage, and then assess your ability to contribute further. If you're still not sure, ask a qualified professional for help.
