Should I max out my 401(k)? This is a common question. After all, when it comes to retirement savings, isn’t more always better? In this blog, we will answer the common question about whether you should max out your 401(k), and things to consider before doing so.
What does it mean to max out 401(k)?
Before we answer the main question, let’s discuss what maxing out a 401(k) means. The IRS imposes limits on what employees can defer out of their paycheck into a 401(k) account. The employer may also match, or do a flat-contribution, into the 401(k) account. The maximum amount the employee is allowed to defer in 2022 is $20,500 for people under age 50 and $27,000 for those age 50 and older. Employer contributions into the employee 401(k) do not count against this limit. There is an overall 401(k) limit of $61,000 into a 401(k) for 2022, so if your employer happens to put a huge contribution into your 401(k), that may limit your ability to max out at $20,500, but the majority of employers won’t be putting that major of a contribution, so we will use $20,500 as the maximum in this blog.
As we have discussed in other blogs, many employers are allowing employees to have access to a Roth 401(k) and a traditional 401(k), meaning you can choose which tax treatment you want for your money. You may be able to choose both types of tax treatment for your 401(k) contribution, but the $20,500 for under age 50 is for all employee contributions combined. So you could put some money into the traditional 401(k) and some into Roth, as long as the combined total doesn’t exceed the IRS maximum of $20,500 ($27,000 age 50 and older). Remember, all employer contributions are traditional.
So with that background, let’s talk about the main question: should you max out that $20,500 (or $27,000 for age 50 and older) employee contribution? To answer that, I will ask you some questions.
Question #1: Do you have any high interest debt, like credit card debt or personal loans?
If you answered yes to this, you may want to consider paying off this debt before maxing your 401(k) contribution. You don’t want to pay more interest than necessary on high-interest debt. If you can, put the minimum in your 401(k) to receive the company match, and then funnel the remainder of your usable budget towards paying off high-interest debt. Once that’s paid off, all of those funds are freed up to do other things, plus, it feels pretty great to be debt-free!
Question #2: Do you have an emergency fund of 3-6 months of living expenses set aside in a savings account?
If the answer to that question is no, then it might be a good idea to set your retirement savings to get your employer match, and then focus on building up your emergency savings. Retirement savings are extremely important of course. But an emergency could happen anytime, and it’s important to be financially prepared if it does. So ensuring you’re prepared to pay your bills and take care of yourself and your family for 3-6 months in the event of a job loss, unexpected expense, etc, should generally take priority over maxing out the 401(k).
Question # 3: Do you have other financial priorities in place?
Things like wills, life insurance, disability insurance, and health insurance can protect you and your family from financial catastrophe in the event life doesn’t go as planned. If you need these in place, and don’t have them, consider prioritizing here before maxing the 401(k).
Question #4: Do you know the investment choices and fees in the 401(k) account? Are they good ones?
Not all 401(k) plans are created equal. Some have a solid investment lineup in which you can pick and choose the best options for you, and some have very limited choices with more expensive investments. Let’s say your plan has limited investment choices and the expense ratios (cost to invest) are on the higher end. Now let’s assume you have $21,000 in your budget each year that you are able to save for retirement. Should you max the 401(k) out and use $20,500 of that budget? Another option may be to max out your Roth IRA or Traditional IRA at $6,000 (or $7,000 for 50 and older) each year and then put the other $15,000 into the 401(k). This allows you to use all of the money you are able to put into retirement, but you are able to choose the better investment options in the IRA.
Question #5: Have you calculated your retirement needs and other financial goals?
This can be a bit involved, so we do recommend you speak to a credentialed financial planner who can help you with this, but calculating your retirement needs is a big step in retirement planning. If you are in your 20’s, you may not need to max out your retirement savings the same way someone starting out saving in their 40s would. That’s not to say don’t do it if you are in your 20s, but you may have a little more leeway to hit some other financial goals you might have if you are starting to save young.
How much money will I have if I max out my 401(k) for 20 years?
The answer to this depends on how you invest your 401(k) and how much the market grows over 20 years. Putting your money into a 401(k) alone does not guarantee a specific amount of growth. Investing your money over 20 years in a mix of diversified low-cost index funds can be the best way to grow your money for retirement.
For example, if you contributed $19,500 per year for 20 years, and your account earns an average yield of 7%, you will have an account balance of almost $900,000 at the end of 20 years. This does not include any employer match that also would have gone into your 401(k) over those 20 years. The employer match does not count against your maximum yearly contribution.
What percentage should I contribute to my 401(k)?
A general rule of thumb is around 10-20% of your gross income. This can vary widely depending on each person’s goals, age, risk tolerance, and more. However, if you consult with a certified financial advisor, they will be able to help you make a decision on how much you should contribute to your 401(k).
What happens when I max out my 401(k) for the year?
If you max out your 401(k) every year, then your savings could grow significantly over time due to compound interest. Check the contribution limits each year to see if they have increased so that you can continue to max out your 401(k).
Is it better to max out 401(k) early in the year?
There is no real benefit to maxing out your 401(k) early in the year. If your company offers the employer match, then you may not want to max out your 401(k) early in the year, because if your contributions stop due to maxing out, then the match also stops. If you don’t have the employer match, then it may be okay to max out your 401(k) early in the year.
Another consideration is the current market. In 2013, maxing out your 401(k) early in the year would have been beneficial because the market rose 32% for the year. However, if you had used that same tactic in 2008-2009, you would have lost money because the market fell from the beginning of the year.
In general, dollar-cost averaging works better over time than market timing. So adding money through the whole year rather than all at the beginning is likely the best strategy long-term.
Can you max out 401(k) and IRA?
Yes, you can max out both your 401(k) and your IRA in the same year as long as you meet the different eligibility requirements. The contribution limits do not overlap.
You can put the maximum allowable into your 401(k) and into an IRA each year. You will want to make sure that you don’t over contribute to your IRA and that you keep track of any IRS eligibility requirements so that you don’t end up paying any penalties if you weren’t qualified to contribute to an IRA.
Saving for retirement is a balancing act between wanting to ensure you are taking care of your retirement needs, while also making sure you’re taking care of your needs (and wants) between now and retirement. Speaking to a professional can allow you to take the guesswork out of these decisions. If you want to speak to one of our advisors about your finances, schedule a complimentary discovery call today!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.