3 Reasons Not to Max Out a 401(k)

Saving for retirement is one of the most important things you can do, as you can't live on Social Security alone. Since Social Security replaces only around 40% of pre-retirement income, you'll need money from other accounts to help cover your needs.

A 401(k) can be a great account to contribute to, if your employer offers one and matches your contributions. An employer match is free money that should never be passed up, and you should contribute enough to get the full amount you are eligible for.

Most employers cap the amount they'll match, though. And 401(k)s have contribution limits well above what most employers will match. In 2023, for example, those under 50 can contribute up to $22,500 to a 401(k), while individuals 50 and up can make an additional $7,500 catch-up contribution for 2023.

Chances are good you aren't going to be able to afford to max this out. But, even if you can, you may not want to. Once you've contributed enough to get your full employer match, there are three good reasons you may not want to put additional investment funds into your 401(k). Here's what they are.

1. You have more limited investment options in a 401(k)

One of the biggest reasons not to put extra money into a 401(k) is that your investment options are often limited.

Research has shown that the typical 401(k) offers anywhere from 13 to 27.5 different investment options. These investments are often mutual funds or target date funds. By contrast, if you open a retirement investment account (like an IRA) with a brokerage firm, you can generally invest in almost any asset available. You can buy mutual funds or target date funds, but also stock shares in individual companies as well. It can be far better to devise an effective investment strategy when you have a virtually unlimited number of options, versus a few dozen or fewer.

2. You may get stuck with higher fees

401(k) plans sometimes charge administration fees, which could average as high as 1.19% for smaller plans. Fees eat into your returns and can make a really big impact over time.

Let's say that over 30 years, you invest $10,000 per year in a 401(k) with a 1.19% fee and you earn a 10% average annual return. Your total account balance will have $329,263 less in it than if you had not paid this added cost. You'd end up with around $1,315,677 instead of the $1,644,940 you could have had.

You could instead opt to open a tax-advantaged IRA with a brokerage firm that charges no fees and put money into that account after you've earned your full employer match. On all that extra money you keep out of your 401(k), you could avoid any administrative fees at all.

You can ask the HR department or your plan administrator what your fees are to find out if you're taking a hit. Your 401(k) investment options may also be more expensive than the investments you could access with a brokerage firm, so be sure to check expense ratios to find out if you'll incur even more costs.

3. You may want to diversify your accounts

Finally, the last big reason you may not want to max out a 401(k) is you may want to diversify the accounts you're investing in, especially if you have limited funds.

For example, if you invest in a traditional 401(k), you get a tax break in the year you make contributions but have to pay taxes on withdrawals. A Roth IRA, on the other hand, allows you to take money out tax-free -- although you don't get that upfront deduction for contributions. You may want to put some money into a Roth IRA so you can get some tax breaks now and some later.

Alternatively, you may want some money in a taxable brokerage account if you expect to need access to invested funds before age 59 ½, as you generally pay a penalty for early withdrawals to access your funds in a 401(k) earlier than that age.

For all of these reasons, you should think carefully about whether to max out your 401(k), or even to contribute more above what your employer will match. You may just find you're better off getting that match and then investing the rest of your money in a brokerage account that offers some other benefits.