Outside of pensions, which are a dying breed, 401(k) savings plans are probably the best retirement vehicle available to the average investor. But unlike a pension, which is managed for you by the company, you have to manage a 401(k) yourself. So it is imperative to be in the know about investing and have a strategy to maximize your savings.
If you read The Motley Fool regularly, hopefully, you are gaining knowledge about how to be a smart investor. There are thousands of articles on Fool.com to help you do that. This article focuses more on the strategy and, specifically, why it may not be the best idea to max out your 401(k), at least not right away. Here are a few reasons why.
Why you don't need to max out your contribution
As you may know, there is a maximum limit on how much you can contribute to your 401(k) plan. But many investors may not know just how high that limit is. For 2023, the maximum 401(k) plan contribution is $22,500 per year for most people. But if you are age 50 or older, that bumps up to $30,000.
If you are 40 and make $50,000 per year, $22,500 is 45% of your annual salary. Keep in mind that this is the maximum you can contribute to your plan in a year, but the amount of your company match doesn't change the more you contribute. For most employers, the match applies up to 4% to 6% of your salary -- with some variations.
Unless you live rent-free, that just would not be feasible for most people receiving that type of salary; you'd have a hard time simply meeting expenses, let alone having any disposable income to enjoy life. Even if you did live rent-free, you probably wouldn't need to sacrifice that much of your current income to build a comfortable retirement nest egg.
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If you simply met the company match at, say, 4%, started at age 40, and invested wisely with a 10% average annual return, you'd have about $526,000 in your plan at age 65, assuming a 3% annual raise. Even with an 8% annual return, you'd have about $400,000 in that same scenario.
In addition, contributing the maximum to your plan, aside from gobbling up your disposable income, would also likely preclude you from investing outside your 401(k) plan. Company plans are typically limited to a roster of broad funds encompassing a few market cap sizes and investment styles, along with company stock if you work for a public company. They also typically have broad retirement target date funds, which are more conservative and rebalance the closer you get to retirement.
These are great options you should take advantage of, but you also may want to have the ability to improve your returns by investing in stocks and exchange-traded funds (ETFs) outside of the limited options in your 401(k) plan.
Also, if you did max out your contributions and then realize you need money for a big investment -- like a down payment on a house, home repairs, or college -- you will be hit with a 10% early withdrawal penalty, in addition to the federal, state, and local taxes you will owe on the distribution.
When contributing the maximum might make sense
Now, there are some scenarios where it makes sense to max out your 401(k). If you or your spouse are pulling in a high salary -- say $200,000 or more a year -- contributing $22,500 per year would not have the same type of impact on your day-to-day life. And you could max out your contributions for a time to rapidly build up your nest egg, then dial it back at any time if you lost your job, took a pay cut, or had a major expense.
However, it would also be smart to have a sizable savings account or rainy-day fund to help with current expenses should you lose a job or take a pay cut.
The other scenario in which it would make sense is if you are over 50 and have saved very little for retirement up until that point. Contributing $22,500 -- or even up to $30,000 per year if you are over 50 -- would help you make up for lost time. But again, that might be unfeasible if you are putting a kid or two through college or have other major expenses.
For most people, contributing the maximum to your 401(k) not only is unfeasible but also doesn't really make sense, particularly if you have a good long-term strategy.
