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.
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 is $19,500 for people under age 50 and $26,000 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 $58,000 into a 401(k) for 2021, so if your employer happens to put a huge contribution into your 401(k), that may limit your ability to max out at $19,500, but the majority of employers won’t be putting that major of a contribution, so we will use $19,500 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 $19,500 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 $19,500 ($26,000 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 $19,500 (or $26,000 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 $20,000 in your budget each year that you are able to save for retirement. Should you max the 401(k) out and use $19,500 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 $14,000 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.
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 30s and 40s professionals 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.