Many people have access to a 401(k) plan through an employer. And the nice thing about 401(k)s is that they come with generous contribution limits -- limits that are much higher than what you'll find in an IRA.
This year, 401(k) plan contributions max out at $23,000 for savers under age 50 and $30,500 for those ages 50 and over. And if you have the means to do so, you may be tempted to max out your 401(k).
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But is that the best move? Here are some pros and cons you should know about.
Pro #1: You'll be setting a lot of money aside for retirement
Contributing $23,000 or $30,500 to an employer retirement plan means you're setting aside a lot of money for your future. In fact, maxing out for a single year could go a really long way.
Let's say you're 27 and contribute $23,000 to your 401(k). Let's also assume your plan gives you an 8% average annual return on your investments over time, which is a touch below the stock market's average. By age 67, you could be sitting on about $500,000 -- from just a single year of contributions.
Pro #2: You'll shield a lot of income from taxes
If you put your savings into a traditional 401(k), as opposed to a Roth, you'll shield $23,000 or $30,500 from taxes if you max out this year. That could lower your tax burden substantially at a time when you may be earning more interest from money you have in savings and CDs.
Pro #3: You'll have options if you're a hands-off investor
It's common for 401(k) plans to offer a couple of good choices for people who don't consider themselves hands-on investors. For one thing, you could always put your money into a target date fund. That fund will then adjust your risk allocation based on how far or close your retirement date is.
Index funds are another common option you'll often find in a 401(k) plan. Index funds are passively managed and have the goal of matching the performance of the market benchmarks they're tied to. Investing your 401(k) in a broad market index fund, like an S&P 500 fund, could be a relatively easy means of growing wealth.
Con #1: You could end up facing hefty fees
You may, unfortunately, face a host of fees if you max out your 401(k). In addition to administrative fees, you could get stuck with costly investment fees if you choose a target date fund for your money.
Mutual funds are another popular investment for 401(k)s. And those, too, tend to impose higher fees for being actively managed.
Con #2: You may not grow your money as much as you'd like to
While target date funds are a really good "set it and forget it" type of retirement investment, the downside, apart from potentially high fees, is that you may not score the best returns. The result? Less money for your retirement.
Now you may find that you fare perfectly well with a broad market index fund over time. But if your goal is to outperform the stock market on a whole, then you'll need a retirement portfolio of hand-picked stocks. And with a 401(k), you can't get that, since these plans generally do not allow you to hold stocks individually.
Con #3: You might struggle to access your money in the event of an early retirement
While you can snag a nice tax break on the money that goes into your 401(k), on the flipside, the IRS will usually hit you with costly penalties if you take a withdrawal prior to age 59 1/2. Now there can be exceptions for people who separate from their employers starting at age 55 and tap their most recent 401(k)s. But for the most part, with a 401(k), your money is restricted until you're 59 1/2 years old. That could prove problematic if you decide you want to retire early.
Of course, this problem might also arise if you house your retirement savings in an IRA. IF you're pretty certain you'd like to retire early, you may want to avoid maxing out a 401(k) and instead invest some of your retirement funds in a taxable brokerage account.
Maxing out a 401(k) is a move that could work to your benefit. But it could also backfire on you. Consider the pros and cons carefully when deciding what to do.
