Should I Max Out My 401(k)? When You Should (and When You Shouldn't)

August 31, 2020

A 401(k) plan is one of the most popular methods for retirement saving in the United States. The plan, which is carefully defined and regulated by the Internal Revenue Service (IRS), enables employees to accumulate wealth with minimal tax obligations and also receive matching contributions from the employers.

It turns out:

  1. A lot people have a 401(k): According to the Investment Company Institute, there are currently 60 million 401(k) plans that are active in some way. That means about one in every three working-age American citizens has access to a 401(k).

  2. However, they’re not aware of it: Some people might even have a plan already established and are entirely unaware of it—this problem is more common than you might initially assume. A recent CNBC report revealed that 63 percent of American workers are confused about their 401(k) or other retirement account.

Collectively, these plans account for a whopping $6.9 trillion of household wealth, which is roughly one-fifth of the nation’s entire retirement savings. In other words, 401(k) plans play a very important role in our broader economic life, particularly for people who are at or are nearing their target retirement date.

Getting to Know Your 401(k)

A 401(k) plan, when managed correctly, is an effective method for saving for retirement and even accumulating generational wealth. When more people have access to 401(k) plans and are able to max out contributions from their employers, systematic and personal inequalities can potentially decrease over time.

However, while the potential benefits of using a 401(k) plan might be apparent, managing these plans is not always so easy. Of course, in theory, people would be putting as much money aside as they possibly can for retirement, but life and other factors can sometimes get in the way. This leads people of all kinds to often wonder, “should I be maxing out my 401(k) plan?”

In this article, we will thoroughly discuss when you should—and, just as importantly, when you shouldn’t—make the decision to max out your 401(k).

When You SHOULDN’T Max Out Your 401(k)

As suggested, a 401(k) plan is a retirement savings plan with minimal tax obligations and the potential for employee matching. Though you will be taxed eventually, using a 401(k) can help defer these taxes and enable you to begin building wealth.

Currently, the contribution limit for employees articipating in a 401(k) plan is $19,500 per year. If you are above the age of 50, you’ll be allowed to make “catch up” contributions, effectively raising the limit all the way up to $26,000! That’s a lot of money, especially if your employer is willing to double or even triple the contributions, as many companies often are.

But, wait, this section is about when you shouldn’t, right?

There’s some penalties for early withdrawal: Your 401(k) should not be treated like an employee-sponsored savings account. Why is that? With a savings account, you can access funds as needed, but with a 401(k) plan, you cannot withdraw without penalty. Any money that is being directed into these accounts should be considered “untouchable” until you reach the age of retirement.

Withdrawing from your 401(k) early carries heavy penalties (usually ten percent), which will erase much of the financial progress you have worked so hard to create. However, some companies, such as Lendtable will actually give you money to max out your 401(k) and cover any of the associated penalties!

Once you are able to reach the point where you have a little extra money at the end each month, you’ll need to decide what to do with each additional dollar that’s left. Plenty of financial planners will have a mindset that says, “maximize your retirement savings and never spend any money”, but this mindset, frankly, is often divorced from real life. There are, in fact, quite a few situations where maxing out your 401(k) might not make sense.

1. You Don’t Have an Emergency Fund

Life happens. And, unfortunately, there are many unexpected moments in life that we end up needing to pay for. Having an emergency fund can help ensure that when the unpredictable inevitably occurs, we can continue living our lives with ease.

According to Vanguard, “Most experts believe you should have enough money in your emergency fund to cover at least 3 to 6 months’ worth of living expenses.” The term “living expenses” in this case refers to necessities like housing, food, transportation, healthcare, utilities, personal expenses, and debt. In the United States, this typically means it is a good idea to have about $10,000 set aside for emergencies. Saving so much money for something that is not even directly benefiting you can be disheartening—many people will want to buy a house or max out their retirement savings as soon as they possibly can. But when an emergency occurs, you’ll be glad you were prepared and that you don’t have your wealth tied up in illiquid assets.

2. You Have High Interest Debt

Debt can be a very useful tool for accessing things we don’t have the money to pay for. If it weren’t for debt, most Americans would not be able to ever go to college, own a home, or even own a car. However, anything that seems too good to be true almost always will be. The burden of debt, simply, is that eventually we are going to have to pay for it.

In a vacuum, maxing out your 401(k) might make sense, but if you have large amounts of high interest debt, doing so might not always be a good idea. When making financial decisions, it is always important to think about the opportunity costs that come with each decision that you make. By choosing to allocate an additional dollar to a retirement account, you are also choosing not to spend an additional dollar paying down your debt.

Paying down debt and building up wealth are goals that will need to be managed in unison, which is why it doesn’t always make sense to go “all in” for one or the other. By using Lendtable, you can avoid the need to choose between spending now and saving for later because you’ll have access to the cash you need upfront.

3. When you need to save for a house

According to the National Association of Home Buyers ( NAHB), about 30 percent of all household wealth is tied into the value of the home. In theory, it is possible to buy a $400,000 home with a $20,000 down payment or even less. If the home is appreciating at a rate of 10 percent per year—not uncommon in many places, especially during this hot housing market—your wealth would effectively increase by $40,000 in the first year through appreciation alone (you’ll also probably build another $8,000 or so in equity, rather than giving it to a landlord).

Of course, this optimistic outlook does not include the many expected and unexpected costs and taxes that come with home ownership. But even still, homeownership itself can be an extremely attractive option for many people. If homeownership is within reach and you are planning on changing your housing situation soon, it might make sense to briefly hold off on maxing out your 401(k).

4. Your 401(k) Fees are Too High

According to an analysis by TD Ameritrade, about 95 percent of 401(k) accounts have at least some fees attached to them. Usually these fees are rather small, but they are not small enough to be completely ignored altogether. Usually, the fees are about a half percent of the account total per year.

A CNBC analysis of this data states, “That means if you have $103,700 invested in your 401(k), which is the average balance among Americans, you can expect to pay about $467 a year in fees. Those expenses range from expense ratios—the actual cost of investments, such as mutual funds and ETFs—to plan administration fees and individual service fees.”

Now, it is unlikely that these fees should deter you from investing in your 401(k) altogether, because it is quite a worthy investment. Nevertheless, they could be just another factor that you will need to actively consider. Depending on your personal financial situation, this is yet another reason you might pass on maxing out this particular account.

5. You Have Other Major Near-Term Expenses

Buying a home and saving for retirement are probably the two biggest financial challenges that will occur over the course of an average person’s life. However, these are just two of the many “very expensive” things you could face that will require intense financial planning. The viewpoint of many retirement planners can be too focused on just retirement—in other words, because retirement saving is their livelihood, they will always defer to saving more for retirement and will tend to overlook the many other aspects of life.

The range of possible major expenses you’ll encounter is nearly limitless. Sending your kids to college, starting your own business, paying outstanding (and interest accruing) medical bills, and going on the vacation you’ve always dreamed of are just a few of the things that might require a large amount of money now. If you are anticipating any of these expenses might pop up in your life, they will need to be incorporated in a broader, comprehensive financial plan.

While in theory, the idea of maxing out your 401(k) might be nice, it is also clear that there are many different reasons you’d prefer to have money in your hand today rather than more money in the future. Talk to companies that will help you navigate these difficulties, such as Lendtable -- you will not need to make the difficult decision of choosing.

When You Should Max Out Your 401(k)

At this point, you might feel a little discouraged from the possibility of maxing out your 401(k). After all, as explained above, there are quite a few situations in which you might want to direct your next free dollar somewhere other than your retirement savings. However, there are also plenty of cases in which maxing out your 401(k) does make financial sense.

Use this checklist to see if maxing out the account is the right decision for you:

  • Employer Matching: the most obvious benefit of the 401(k) account is that your employer can make contributions. If your employer offers matching contributions, that’s great news for you because you can essentially double your savings. If they have a double matching program, then maxing out your 401(k) will be even easier to justify.

  • Multiple Sources of Income: if your household has multiple sources of income, this means you have an additional layer of protection from the future unknown. If you have a working spouse, a side hustle of your own, an income-generating property, dividend producing stocks, or other additional sources of income likely means you are in decent financial shape.

  • Current Financial Stability: having a well-stocked savings account and, in many cases, a home will mean you have at least some degree of financial stability. If you were to suddenly need some funding, you could access it via a home equity line of credit (HELOC), rather than having to dip into your retirement savings. When this is the case, you can probably be more comfortable putting additional money aside each month.

  • Comprehensive Financial Planning: planning your financial future can be very stressful, even overwhelming. Home ownership, retirement, starting a business, sending your children to college, and other financial goals can be difficult to manage all at once, especially all on your own. This is why it is important to find a financial planner that you trust. Even if you only meet with them once a year, they can help answer your questions and compare possible options. What are their thoughts on maxing out your 401(k)?

In the world of financial planning, there is not a universally “best” path that will make sense for absolutely everyone. Your current employment situation, assets, and financial needs will all affect whether maxing out your 401k will be the best choice for you.

401(k) Saving Strategies

Saving for retirement doesn’t have to be an all or nothing commitment. There is a lot of room for growth between not contributing at all and making the greatest contributions you possibly can. If you can only contribute a little bit to your 401(k) in the status quo, that’s okay. Getting started earlier will still be better than waiting until you can make the full contribution.

Many 401(k) plans are designed to “automatically” increase contributions over time. “One strategy I recommend using for plan participants to help them increase their contribution rate is to enroll in the ‘auto-increase feature most company 401(k) plans offer”, said certified financial planner (CFP) Michael Ingram in an interview with AARP, “The way the auto-increase works is it increases your contribution automatically each year by 1 percent until you reach a predetermined cap rate of 10 percent to 15 percent.”

This strategy, effectively, can help you “scale in” to maxing out your 401(k) without needing to make any sudden changes or ignore your financial needs in the status quo. Additionally, it is also important for individuals over the age of 50 to realize they have considerably more flexibility than their younger counterparts. The right to make “catch up” contributions once you reach this age can help make up for any earlier retirement savings gaps.

Another important thing to realize is that your 401(k) plan might just represent one of many different financial vehicles that can be used while saving for retirement.

Other Places to Save After Maxing Out Your 401(k)

If you are already maxing out your 401(k), this means you are heading towards what could be a very lucrative retirement. However, the question that remains is, what do I do with my extra dollars?

Other Retirement Funds

A 401(k) plan is just one of many retirement funds you might consider using. Setting up an Individual Retirement Account (IRA) or Roth IRA can help you grow your savings and manage your tax obligations. You can also consider A SEP IRA, a Health Savings Account, or a Taxable Brokerage Account.

Investing in the Stock Market

The stock market has its ups and downs, but on average, the stock market is almost always moving in a positive direction. Over the course of the last century, the S&P 500—a standard index that illustrates how the stock market is performing as a whole—has yielded a 10% annual return. At this rate, a $1,000 investment today will be worth $17,449 in thirty years.

Home Ownership

Home ownership accumulates wealth through equity (essentially, your mortgage allows you to “buy back” the home from the bank), as well as through asset appreciation (home prices are always going up). Home ownership is also a great way to generate leverage—and, hey, it gives you a place to live.

Giving to Charity

If you’ve maxed out your 401(k), opened other accounts, bought stocks, and own your home, this means you’re doing a great job. Congratulations. At this point, you’re on pace for a nice retirement!

In the meantime, giving money to those in need via charity will help create positive change, build good karma and also give you a nice little tax deductible.

Conclusion

Having a 401(k) plan in place will help set you on the proper road to retirement. However, your 401(k) is just one part of a broader financial plan. There will be plenty of situations in which maxing out your 401(k) doesn’t make sense. But even when this is indeed the case, you’ll find there are still many options out there! Lendtable makes it easy to begin saving now without needing to make too big of a financial sacrifice. Learn more about how Lendtable can help you begin building the wealth you need for a happy retirement.

Rahul Iyer

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