Nearly half of older adults say their biggest financial fear is outliving their retirement savings. Maxing out your 401(k) is an obvious way to reduce that risk. In 2023, the 401(k) contribution limit for workers younger than 50 is $22,500. Those who are 50 and older can contribute $30,000 thanks to catch-up contribution.
There's a big problem with maxing out your 401(k), though: You probably have a lot of financial goals that you want to accomplish between now and retirement. But if you don't earn a top salary, funding your 401(k) to the limit could mean you don't have money left for your other goals.
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What's the problem with putting all your savings in a 401(k)?
The trouble with saving all your money in a 401(k) is that you're not supposed to touch that money until you reach retirement age. That's why the IRS imposes a 10% penalty on distributions made before age 59 1/2, on top of applicable income taxes. (Workers who leave their job for any reason the year they turn 55 or later can typically avoid the 10% penalty on distributions under the rule of 55.)
Then, there's the potential for stock market volatility. Short-term market fluctuations shouldn't matter when you're investing for the long haul. But if you'd be forced to withdraw from your 401(k) in an emergency, those ups and downs matter a great deal.
Imagine you lose your job when the stock market has just tanked. If all of your savings is tied up in a 401(k), you'd be forced to make an early withdrawal before your investments have recovered. Plus, you'd pay the 10% penalty and income taxes on the distribution.
That's why before you even think about funding your 401(k) to the limit, a six-month emergency fund is also vital. Also, before you max out your 401(k), be sure you have enough room in your budget to pay your credit card balances in full each month. Otherwise, the interest you're paying is probably higher than your 401(k) returns.
Retirement isn't the only goal
Retirement is probably your biggest financial goal, but the years leading up to retirement matter, too. Because $22,500 is a substantial chunk of change for most workers, maxing out your 401(k) could stop you from pursuing other goals, like buying a home or saving for your children's education.
Ideally, your budget leaves room for enjoying life. You shouldn't feel guilty about saving for a vacation or a wedding even if you're not maxing out your 401(k). None of us is guaranteed to reach retirement age. It's important to strike a balance between saving for the future while also enjoying the present.
Does it ever make sense to max out your 401(k)?
For some people, maxing out a 401(k) does make sense. Here are some scenarios where it's worth considering:
- You have at least a six-month emergency fund, no high-interest debt, and you don't expect to need the $22,500 you'll invest (or $30,000 if you're 50 or older) until you're retired.
- You're making up for lost time. If you started investing later in life, aiming to contribute as much as you can to retirement accounts is a wise goal, since your money has less time to compound.
- You're hoping to retire early. Again, early retirement means less compounding time, so if you're pursuing early retirement, you'll need to save more each year.
- You earn a high salary and are trying to lower your taxable income for the current year.
Otherwise, instead of aiming to max out your 401(k), try to save 15% to 20% of your salary for retirement. Always contribute enough to your 401(k) to get your full company match, since it's free money. From there, you could make unmatched 401(k) contributions, fund an individual retirement account (IRA), or split the difference between the two.
