You may have heard of the term 401(k) millionaire. These people achieved a million-dollar net worth with the help of a 401(k) retirement plan they funded throughout their working years. Yes, 401(k)s are an excellent financial tool widely available to the working class.
But should you max them out? You can put up to $22,500 into your 401(k) in 2023, but you may not want to for several reasons. Don't get me wrong; many plans offer an employer match, and you should jump on that free money.
However, the bigger picture is more complicated when it comes to maximizing your contributions. Here are three unfortunate truths about maxing out your 401(k).
It could interfere with an early retirement
Considering the maximum contribution to a 401(k) is $22,500 in 2023 (or $30,000 for those 50 and older), and the median U.S. income is $57,000, those able to afford the max contribution likely have high earnings or maintain an abnormally high savings rate. In that case, your financial situation may put you in a position to retire early.
That could be a problem if you concentrate too much of your retirement savings in your 401(k) plan. That's because there are rules regarding when you can start taking withdrawals from your account. In fact, you'll incur a 10% penalty if you withdraw funds before you turn 59 and a half. There are exceptions like the Rule of 55, but that can further complicate things and will cost you if you make a mistake.
This lack of flexibility is an excellent reason to consider spreading your nest eggs across a variety of retirement accounts with different rules and benefits.
You might not want to defer taxes
401(k) plans are tax-advantaged investment accounts, and the traditional 401(k) is tax-deferred. In other words, you invest pre-tax contributions and pay any taxes on that money when you withdraw it in retirement. Your 401(k) contributions reduce your taxable income each year, but what if you don't want that?
For example, if you believe you will be in a higher tax bracket later in life, it might make sense to pay your taxes upfront. In a Roth account, you pay taxes on your contributions in the year you make them, but future withdrawals are tax-free.
Unfortunately, not everyone has access to a Roth 401(k). And in such cases, you should be aware of how contributions to your 401(k) might end up sticking you with a higher overall tax bill. So, carefully consider the tax implications of investment and retirement planning decisions.
Most 401(k) plans lack investment choices
Lastly, 401(k) plans are notoriously simple. That's a good thing in some cases. You might be someone who doesn't want to put a lot of thought into their retirement plan. You're happy to select one of the cookie-cutter investment funds offered and move on with your life.
But if you'd like to be more involved in your investing choices or perhaps own some individual stocks, you don't have that option in most plans. The lack of choices could limit your potential investment returns or prevent you from deploying your money with your desired strategy. It's something to remember when you plan out your 401(k) contributions.`
Despite the potential flaws, 401(k) plans are powerful wealth-building vehicles, and they do much more good than harm. You shouldn't hesitate to participate in a 401(k) if one's available, especially if there's an employer match. But do think twice before putting all of your nest eggs in that one basket.
