Maxing Out Your 401k is Usually a Bad Idea

The most you can contribute to a 401k plan in 2024 is $23,000 per year or $30,500 per year if you are 50 or older. The total amount that can be contributed to your 401k can be higher if your employer offers to match a percentage of your contributions.

If you are in the position to make the maximum contribution to your 401k plan you are doing well. It means that you have $23,000 or $30,500 of income per year to invest. The question is this. If you are in the position to max out your 401k, is it the best use of your money to do so?

Maxing out your 401k is not inherently wrong. In fact, it says some good things about you. You are thinking about your future, and you have a good income. However, if there is a better place to send your dollars to instead of maxing out your 401k, then maxing out your 401k is not a good idea.

The advantages of the 401k are twofold. First, it is easy to use. Once you select your 401k investments, a portion of your paycheck is automatically contributed to the account. This allows you to sit back and not be worried about investing as it is automated.

Secondly, many employer's offer a matching contribution. Some people say this is "free money" that you should take advantage of. This is not entirely true as your 401k plan may have a vesting schedule, but if you can get a match from your employer it will help you invest more.

When you invest, the goal is to maximize the benefits of different accounts and investments while minimizing the drawbacks of those accounts and investments. You should consider some of the drawbacks of the 401k before maxing it out.

The first disadvantage of a 401k plan is that the plan offers limited investment options. Your employer gets to decide what type of investments your plan offers. This might include a mix of index funds, mutual funds, and target date retirement funds that offer different types of stocks and bonds.

If you don't like the investments that your 401k plan has to offer you are out of luck. This is one of the reasons that you might not want to max out your 401k plan. If you would rather have more control over your investments, you can contribute some of your money to your 401k, and some of your money to other investing accounts that allow more flexibility with your investments.

Since 401k(k)s are employer sponsored retirement plans, your employer has control over the plan. They get to decide what investments your plan offers, when you can start participating. and how much of a matching contribution you will get.

Some employer's also have a vesting schedule for their matching contributions. A vesting schedule is simply how long it will be until your employer's contributions are yours. For example, if your employer has a 1 year vesting schedule, their matching 401k contributions won't be yours for a year.

If you were to leave the company before a year, you would not get to take any of the matching contributions. You may also find yourself in the position in which your employer does not offer a 401k plan. This is less common, but it may happen.

Since 401k plans are designed to help you save for retirement, you can't access the money until you are 59 and a half years old. If you try to pull the money out before then, you can incur a 10% early withdrawal penalty as well as any applicable income taxes.

This rule is not a complete disadvantage. The point of the 401k is to help you save for retirement. If you were able to touch the money throughout the course of your life, it would defeat the purpose of the account. However, if you were to max out your 401k with all of your available dollars, you won't have any access to that money.

For this reason, it can be worth sending some of your dollars to financial tools that allow you to access money throughout your life. The reality is that at some point in your life, you will likely need access to capital to help you. If you max out your 401k, you lose accessibility.

Many 401k plans are Traditional 401k plans. A Traditional 401k plan offers what is called a tax deferred benefit. This means that you get a tax deduction on the contributions you make today, and will pay taxes on the money when you withdraw from the account in retirement.

In other words, you wait to pay taxes. In certain cases this can work against you. For example, say that you currently pay 25% in taxes. Assume that you are going to live off the same amount of money in retirement as you do today adjusted for inflation.

If taxes were to rise where you would pay 30% in taxes, a 401k plan would be working against you in the tax department. The reason for this is that you waited to pay taxes until you retired when taxes were higher. It is hard to determine if taxes are going to be higher in the future, but if they are maxing out your 401k is not always your best bet depending on your individual circumstances.

You can get around this problem if your employer also offers a Roth 401k. A Roth 401k does not give you a tax break today, but you won't pay any taxes in retirement. If taxes go up in the future, it would be better to use a Roth 401k as opposed to a Traditional 401k. The problem with this is that not all employers offer a Roth 401k.

You may have gotten the impression from the points above that the 401k is a bad financial product. While it does have a plethora of disadvantages it also has a few advantages. The main advantage of a 401k plan is your employer's matching contribution.

You want to contribute enough to your 401k to get your employer's full match. For example, say that you make $125,000 per year and your employer offers a 4% matching contribution. You want to contribute 4% of your salary ($5,000) so that your employer will match that with another $5,000.

You may have heard that this is "free money." However, as previously noted your 401k plan may have a vesting schedule. It is important to ask your employer if their 401k plan has a vesting schedule so you can be aware of when their matching contributions are fully owned by you.

Once you get your employer match, it may be better to stop funding your 401k and instead start funding an IRA. An IRA, or individual retirement account, is an investing account designed to help you save for retirement.

Unlike a 401k, an IRA is held outside of work. This will give you more control over the investments you want to hold in the account and the account itself. There are two main types of IRAs - the Roth IRA and the Traditional IRA.

The Roth IRA allows you to contribute after tax dollars to the account. The money within the account grows tax free and when you pull it out in retirement, you won't pay any taxes. The Traditional IRA allows you to contribute to the account with after tax dollars as well.

However, you may be able to deduct your contributions to a Traditional IRA depending on your income and whether or not you have a 401k plan. When you pull the money out of a Traditional IRA, you will pay taxes on the money you withdraw.

There are limitations to these accounts such as eligibility requirements, contribution limits, and withdrawal rules. However, adding in an IRA as opposed to maxing out your 401k, will give you more flexibility in terms of what you can invest in.

Once you have gotten your employer's match and have funded an IRA up to the limit, you can consider other investments such as real estate. Buying rental properties and managing them is not easy, but for some investors the pros outweigh the cons.

Rental properties can provide monthly cash flow, tax benefits, and appreciation of the property itself. If you are an investor that loves and understands real estate, you could skip the IRA step and use that money to invest in real estate if you are able to handle the risks that come along with it.

Once you have gotten your employer's match, and have considered an IRA, real estate, or a combination of both, you may want to contribute any excess money to financial products that give you access to capital. Retirement accounts, such as the 401k and IRA, do offer benefits.

401(k)s have an employer match and are easy to use, and IRAs give you flexibility with your investments while providing tax benefits. However, both of these accounts have a major problem. You don't have any access to the money within the account throughout your life.

When you contribute to these accounts, you lock up your money until you are 59 and a half years old. For this reason, you can divert any extra money you have to financial products that give you access to capital. For some, this may simply be building an emergency fund in a high yield savings account.

While having an emergency fund is important, whole life insurance is a product that will give you access to capital throughout your life. When you contribute to a whole life policy, your money goes into three buckets. One bucket covers the cost of your insurance, one covers administrative costs, and the third bucket goes into what is called a cash value component.  

This cash value will earn interest and grow over time. Throughout your life you can access this cash value by taking withdrawals, and borrowing against the cash value. There are no restrictions on when you can access this money or what you can use it for.

Some individuals will say that whole life insurance is an investment. This is not entirely true. The point of a whole life insurance policy is to give you access to cash. IRAs and 401(k)s don't offer this so adding in a whole life insurance policy can make sense for some individuals.  

The steps listed above have focused on other places you could invest your money besides your 401k plan. Beyond investments, you may also consider using money that would have gone to your 401k for other financial goals.

This might include saving for a house, saving for a vacation, paying off true debt, and more. In this step, you can look at your total financial picture and see what you want to accomplish. If you were to dump excess money into your 401k plan, you won't be able to use it in other areas.

If you find yourself in the rare scenario in which you still have money left over to invest after going through the steps above, you can jump back to your 401k. When you go through the steps above, you have maximized the benefits of the account and minimized the drawbacks of the account.

Up until this point, we have made the argument that maxing out your 401k is not always a good idea. If you have $23,000 per year or $30,500 per year if you are 50 or older to invest, there are ways to be more efficient with that money as opposed to dumping it all in a 401k plan.

However, that does not mean it never makes sense to max out your 401k. If your income is very high, it can make sense to max out your 401k. Doing so will give you a large tax deduction and will help you stack away large amounts of money for your future.

The point we have been making is that it is important to be efficient with the money you have. It does not matter if you make a little bit of money, or a lot of it. You want to look at the available dollars you have and figure out the best place to allocate those dollars.

If you immediately jump to the conclusion that you should max out your 401k, you may be leaving better options on the table. Figuring out whether or not to max out your 401k can be challenging. For this reason, it can be worthwhile to work with a financial advisor as everyone's financial situation and goals are different.

The bottom line is that maxing out your 401k is usually a bad idea. One of the keys to winning with money is to be efficient. You want to maximize the benefits of particular investments or accounts while minimizing the drawbacks.

If you are in the position to max out your 401k and do so, you are not being as efficient as you could. Instead what you should do is contribute enough to your 401k to get your match, and then look for other investments or accounts that have benefits that 401k plans do not.