Pros and Cons to Maxing Out Your 401(k) Take a look at the pros and cons of maxing out your 401(k) outlined below. You might find these tips especially helpful as you try to go beyond your employer match.
This story originally appeared on MarketBeat
Someone might at one point have said to you, "You've got to max out your 401(k)! Such a great idea!"
But is it? Your situation might dictate a completely different approach. For example, let's say you have a lot of high-interest debt. In that case, maxing out your 401(k) might not make the most sense for your personal situation.
Take a look at the pros and cons of maxing out your 401(k) outlined below. You might find these tips especially helpful as you try to go beyond your employer match.
What Does it Mean to Max Out Your 401(k)?
Employees can contribute up to $19,500 to a 401(k) in 2021. Those 50 or older can add in an additional $6,500 catch-up contribution. Maxing out your 401(k) means you would have the following amount by age 70 if you started saving $19,500 in your 401(k) every year at the following ages. We'll assume a 6% rate of return:
- Age 25: $4.48 million
- Age 30: $3.24 million
- Age 35: $2.32 million
- Age 40: $1.63 million
- Age 45: $1.13 million
Does it make you want to run right out and max out your 401(k)? Tempting, especially if you know that many experts suggest having 10 times your annual salary by the time you turn 67.
Should You Max Out Your 401(k)? It Depends.
No matter what, keep in mind that experts advise that you save between 10% and 20% of your gross salary toward retirement. You want to save as much for retirement as you possibly can within comfortable living standards.
Pros to Maxing Out Your 401(k)
Check out the following pros to maxing out your 401(k). If these pros fit your needs, you may choose to head down to your human resources office and sign up to max out your 401(k) immediately!
Pro 1: Reduces taxable income.
When you invest in a tax-deferred 401(k) plan, this means that your contributions get deducted from each paycheck before taxes. Money comes out on a pre-tax basis (unless you choose to opt for a Roth 401(k) instead of a regular 401(k), which moves your money into your retirement account after taxes). Pre-tax 401(k)s lower your taxable income, which means you pay less in tax when you file your taxes.
Different retirement accounts handle taxes differently. Some defer paying income tax on your retirement savings and others help you avoid paying tax on gains. You could:
- Save $4,680 in taxes if you're in the 24% tax bracket and contribute your max amount.
- Save $7,215 in taxes if you're in the 37% tax bracket and contribute the max amount.
- Double your tax savings if you and your spouse both contribute to a 401(k) each.
Pro 2: Helps you save enough to retire someday.
If you choose not to max out your 401(k), does that mean that you won't have enough to retire someday? Of course not! You can still save a lower amount and still have enough money saved for retirement. However, saving $19,500 per year gives you an edge and you guarantee that you save more quickly for retirement.
Pro 3: You give compound interest a chance to do its job.
When you invest $19,500 at age 25 every year until you turn 70, you'll have $4.48 million at a 6% interest rate. Investing early gives you a major advantage because you let your money grow using the magic of compounding.
Even if you're not 25 at this point, you can still take advantage of compounding. Case in point: You'll have $1.13 million at 6% interest if you start maxing out your 401(k) at age 45.
Cons to Maxing Out Your 401(k)
Take a look at the following cons before you make a final decision about what to do next.
Con 1: You may tie your money up in illiquid assets.
Maxing out your retirement account every year may mean that you put a relatively large percentage of your money into illiquid assets. (Illiquid assets that you can't take out without paying considerable penalties, to boot. You'll typically face a 10% tax penalty for early withdrawal on qualified retirement plans, in addition to any federal and state income tax on the withdrawal before you reach age 59 ½.)
In other words, unless you want to pay penalties, you consider your money "locked up" when it goes into a retirement account.
When you put your money into liquid accounts, you can take it out when you need it instead of keeping it locked up in an account you can't access. Savings and checking accounts are two examples of liquid assets.
The danger with investing too much in your retirement could mean that you don't save enough in your emergency fund, which should stay very liquid. Experts recommend putting together at least three months' worth of expenses. Save up at least a small emergency fund before contributing anything to your 401(k). After that, divide your spare cash between your 401(k) contributions and your emergency fund. Try to build up to at least six months' worth of everyday expenses or more.
Con 2: You might not have enough to pay back debt.
You may neglect your high-interest debt if you focus on your 401(k) savings instead of your debt. Since the average credit card interest rate is 16.13%, that rate can really do a number on your debt load. The faster you pay off that debt, the sooner you get rid of recurring interest and debt. You may want to consider paying back other kinds of debt as well, such as personal loans or other types of debt.
Maxing out your retirement plan can prevent you from paying off high-interest debt, which could prove a major mistake later on. You may want to put your energy toward your high-interest debt before you tackle saving the max for retirement.
Con 3: You might invest in a plan that isn't very good.
What should you do if your employer's plan charges high administrative fees or offers a limited number of investments? If you do your research and find that the plan isn't ideal, you may choose to invest only enough in your 401(k) to earn the maximum employer match and then put the rest of your retirement money elsewhere.
In this case, you might want to consider investing just enough to get your employer's match, then invest in something else like index funds.
Save the Appropriate Amount for Your Needs
Once you've taken all of these pros and cons into consideration, carefully examine the amount you need for retirement and consider your risk tolerance. Next, decide the 401(k) savings amount that works best for you. You may not feel comfortable with maxing out your retirement, and that's okay. You can still have success investing less, particularly if you have other assets in your portfolio.
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