Should You Contribute the Maximum to Your 401(k)?

Almost everybody hopes to retire one day. The problem is that you need a lot of money saved to have a comfortable retirement.

If you want to make sure that you have enough money to retire, you’ll want to contribute to a 401(k).

To increase the likelihood that you’ll have a good retirement, you might even want to max out your 401(k).

But just because you can max it out, does that mean you should?

How Much Can You Contribute in a Year?

401(k)s are a special type of account that the government designed to help people save for retirement.

There are tax incentives for contributing to a 401(k) and restrictions placed on any amount that you put in the account.

There are limits to how much you are allowed to contribute to a 401(k) each year. These limits ensure that high-earners don’t get to shield the vast majority of their income from taxes.

This limit takes only your contributions into account. Employer contributions do not count towards the limit.

For 2024, you can contribute up to $23,000. If you are at least age 50, you are eligible to make additional catch-up contributions of up to $7,500.

Traditional and Roth 401(k)s

There are two different types of 401(k).

Traditional

The traditional 401(k) is much more common.

When you contribute to a traditional 401(k) you can deduct your contributions from your income when you file your taxes.

That gives instant savings because 401(k) contributions are done by payroll deduction. Sending $1 to your 401(k) will reduce your take-home pay by less than $1.

When you withdraw money from a traditional 401(k) you pay income tax on it.

Roth

The Roth 401(k) is less common, but some companies do offer it. It offers benefits that are the reverse of the traditional 401(k)’s.

You pay taxes on the money when you contribute it to a Roth 401(k). When you withdraw from the account you pay no tax. Even the earnings are tax-free.

The contribution limit is combined for both types of 401(k).

If your employer offers both, you can contribute to both, but cannot exceed the maximum.

Keep in mind that there is an additional catch-up contribution allowed for those turning age 50 or older.

The Case for Maxing Out Your 401(k)

There are a few strong arguments in favor of maxing out your 401(k) whenever possible.

Unbeatable tax savings

If you make enough money to max out your 401(k) you are most likely in a high tax bracket.

Contributing to a traditional 401(k) gives immediate savings equal to your tax rate.

If you’re in the 25% tax bracket, contributing $1 to your 401(k) only costs 75 cents. Put another way, you get nearly a 25% return immediately.

Contributing to a traditional 401(k) offers a nearly unbeatable return in the form of savings on your tax bill.

Free money from employer matches

Many employers offer 401(k) matching as an employee benefit. Your employer may match your contributions at a certain rate, up to a certain amount contributed.

For example, an employer may offer a 100% match on up to 5% of your salary in contributions.

If you make $50,000 a year and contribute $2,500 (5% of your salary), your employer will also contribute $2,500 on your behalf.

This is like getting an immediate 100% return on your investment.

You should always contribute to your 401(k) up to the maximum employer match if you can.

Can serve as emergency savings 

A 401(k) is designed to be used for retirement savings, but you can still withdraw money from the account before you retire.

The downside is that you will have to pay a penalty if you do make an early withdrawal.

If you withdraw from a traditional 401(k) before turning 59½, you will have to pay a 10% penalty on the amount withdrawn, plus any applicable income taxes.

This is a significant cost to bear, but if you truly need the money, a 401(k) can serve as a last resort source of funds in an emergency.

Helps build a healthy retirement

Maxing out your 401(k) lets you build a truly comfortable nest egg for retirement.

Consider this example. When you turn 30, you decide to start contributing to your 401(k) for the first time.

In fact, you decide to max it out, contributing $18,500. Your employer match brings the total contribution to $20,000. You continue to add $20,000 to the account each year with your own and your employer’s contributions.

If the account earns 8% each year, which is below the U.S. stock market’s average over the past century, you’ll retire at 60 years old with $2.4 million in your 401(k).

Maxing out your 401(k) puts you on the path towards a great retirement.

Even if you only contribute half of the maximum you can easily wind up a millionaire by retirement.

The Case for Not Maxing Out Your 401(k)

There are some cases in which you might not want to max out your 401(k).

You have high-interest debt

If you have high-interest debt, you’re likely to be better off paying it down before saving for retirement.

The U.S. stock market has returned an average of 9-10% per year, but with significant variance.

If you have loans that charge rates near or above that number, you should prioritize paying them off first.

Another reason to pay off loans is that you can eliminate a monthly payment by doing so, making it easier to make ends meet.

You need to build an emergency fund

You should prioritize building an emergency fund over saving for retirement if you don’t already have one.

Emergency funds can be the difference between handling an unexpected bill and going into expensive credit card debt.

Ideal Size of an Emergency Fund

You definitely don’t want to rely on your 401(k) as an emergency fund.

If you do have to withdraw from the account to cover an emergency expense, you’ll have to pay a tax penalty.

First, build an emergency fund in an online savings account.

You’re saving for a major purchase

If you want to be a homeowner, or need to make some other huge purchase, you might decide to prioritize saving towards a down payment rather than saving for retirement.

You can’t use your 401(k) to buy a house, so you need to keep your down payment savings outside your retirement account.

Whether you want to prioritize your major purchase or retirement is your decision, and what you decide affects how much you’ll contribute to your 401(k).

Expensive 401(k) plans

There are administrative fees that apply to 401(k) plans. If you have a bad one, you're paying a small percentage of your portfolio for this unavoidable fee.

Every single fee is slowing down the growth of your investments.

Furthermore, the fund options in your 401(k) may be limited and/or carry high expense ratios.

If your 401(k) plan has high administrative fees and bad funds, your retirement savings is going to suffer significantly.

How Much Should You Contribute?

If you can’t max out your 401(k), or aren’t sure if you should, you’ll have to decide exactly how much you want to contribute.

Contribute a percentage of your income

One of the most common ways to determine your 401(k) contribution is to contribute a percentage of your income.

In fact, many employers automatically enroll new employees in their retirement plan, setting default contributions of 5-10% of income.

Most retirement experts recommend that you save 10-20% of your annual income, so try to contribute that much to your retirement plan.

Make sure to max out the company match

If you work for a company that offers a 401(k) match, always contribute up to the maximum matched amount if you can.

Getting the matching contributions is like getting free money, and you don’t want to pass that up.

Calculate How Much You Need to Retire

If you have a good handle on your finances, you can estimate how much you spend each year now.

You can also take a good guess at how much you’ll spend in retirement. Using that information, you can estimate how much money you need to retire.

The 4% rule is a baseline saying that you can withdraw 4% the starting balance from your retirement account each year, and you won’t run out over the course of a normal retirement.

So, if you have $1 million in your 401(k) when you retire, you can withdraw $40,000 per year without worry.

Figure out how much you’ll need each year and multiply that number by 25 to find out what retirement account balance you’ll need to have at retirement. Then do the math to determine how much you need to save to reach that level.

Don’t forget to factor in different potential investment returns and income from Social Security.

Determining your contribution this way is complicated, but if you want to save exactly the right amount, this is the way to do it.

Use Your 401(k) and IRAs

If you find yourself with an expensive 401(k), you should use both your 401(k) and an IRA. IRAs offer the same benefits as 401(k)s, but with lower contribution limits ($6,000 in 2021). With an additional $1,000 catch-up limit if you're 50 or older.

The benefit of IRAs is that you can open one anywhere, so you can choose a provider that offers low-cost investments.

The rule of thumb is to contribute to your 401(k), regardless of cost, up to the maximum employer match.

The immediate return from the match will offset nearly any fee. After that, max out your IRA and choose low-cost investments.

Only once you’ve maxed out the employer match and your IRA should you return to contributing to the 401(k). Even if you have expensive investment options, the tax savings will make it worth it.

If you plan to stay with your employer for a long time, you can always campaign for lower cost investment options in the 401(k).

If you leave your employer, you can roll your 401(k) balance into your IRA.

Maxing out your 401(k), despite the high costs, lets you get the most tax-advantaged money possible.

You can worry about getting the money into lower-cost investments at a later time.

Conclusion

Maxing out your 401(k) is an admirable goal and people who want to have a good retirement should try to do so.

If you can’t afford to max out your 401(k) make sure to contribute enough to get your employer’s match and try to increase your contributions by a little bit each year.

Saving even a little bit is still saving, and can get you into the habit of planning for the future. Plus, even small amounts can grow to significant sums given time to grow in the stock market.