Retirement accounts and the 401(k) have become somewhat synonymous. By far the most popular type of retirement account is the 401(k), with close to 35% of working-age people (age 15 to 64) having one or an equivalent like a 403(b). The percentage is even higher for adults when you consider that most jobs for teenagers don't offer a 401(k).

When it comes to saving for retirement, the idea has always been the more, the better. That's why maxing out a 401(k) seems like a no-brainer. However, the unfortunate truth about maxing out your 401(k) is that it's overrated.

Someone sitting at a table holding a coffee mug and looking out the window.

Image source: Getty Image.

Your investment options will be noticeably limited

When you contribute to a 401(k), your plan provider gives you investment options to choose from. It varies by plan, but most have a combination of the following:

  • Market cap index funds (large, mid, and small)
  • International index funds
  • Target-date funds
  • Your company's stock

For some investors, the fewer options and more hands-off they can be, the better. These investors embrace the true meaning of "set it and forget it." For other investors, the provided options limit how they can tailor their investments to match their financial goals and risk tolerance.

Suppose you want to invest in companies like Apple, Microsoft, or Amazon, but you don't work for those companies. You couldn't buy those individual stocks in most 401(k)s, aside from them being holdings in the available target-date or index funds. Yet that would have caused you to miss out on spectacular long-term gains.

AAPL Chart

Data by YCharts

You'll be facing tough withdrawal rules

The purpose of a 401(k) is saving for retirement, and the IRS makes sure it sets limits in place so you use it for just that.

Generally, you can't withdraw from your 401(k) until you're 59 1/2 years old. Doing so before that will trigger a 10% early withdrawal penalty, and you'll also owe taxes on the amount. For example, if you withdraw $50,000 early, you'll face a $5,000 penalty plus relevant taxes. Depending on your tax bracket, you could receive an amount way below your withdrawal.

The same 10% early withdrawal penalty also applies to IRAs, but they have more permissive withdrawal rules. Here's how exceptions to the 10% penalty stack up between a 401(k) and IRAs:

Exception Applies to 401(k) Applies to IRAs
Disability Yes Yes
Education No Yes
First-time home purchase No Yes
Medical reimbursement Yes Yes
Medical insurance premiums No Yes

Data source: IRS.

It would be best if you didn't want to take money from your retirement accounts, but sometimes life happens. You just never know. Even if you don't want to withdraw, it's nice to have more penalty-free options with an account like an IRA.

Maxing out a 401(k) just isn't feasible for most people

The maximum contribution someone can make to a 401(k) in 2023 is $22,500 ($30,000 if they're 50 or older).

According to the U.S. Census Bureau, the median U.S. household income is just over $70,000. Needless to say, that makes saving $22,500 to $30,000 annually a tough ask and downright impossible for many people.

Yes, you should always want to save for retirement. There's no doubt about that. However, you don't want to completely jeopardize your current livelihood trying to do so. It's more than understandable if you don't max out your 401(k).

At a minimum, you should aim to contribute the most your employer will match. Contributing anything less than that is leaving money on the table. For example, if you make $80,000 and your employer matches up to 5%, only contributing 3% would cause you to miss out on an extra $1,600. That's not only money missed in the present, but it's also money that never had the chance to grow and compound.

Every dollar matters in retirement. Make sure you're taking every opportunity to maximize yours.