Are You Maxing Out Your 401(k) Account? Should You?

by Vered DeLeeuw · 18 comments

I always assumed that we should all contribute as much as we can to our 401(k) accounts. After all, an employer sponsored retirement account allows our savings to grow tax-free, which is a major benefit, especially for those of us in higher tax brackets.

Maxing out your 401(k) means contributing the maximum dollar amount permitted for the current year. The annual contribution limit for 401(k) accounts is $16,500 in 2010 and in 2011. If your annual salary is, say, $100,000 per year, that’s 16.5% of your pre-tax income, which is a good amount to save annually according to experts.

But even if you manage to save that much, should you put it all into your 401(k)? Some say you shouldn’t.

401(k) Plans Have a Couple of Major Flaws

1. 401(k) Withdrawals Are Taxed as Ordinary Income. While 401(k) accounts allow your pre-tax dollars to grow tax-free, withdrawals from these accounts are taxed as ordinary income, instead of at the lower rates of long-term capital gains. This reduces the after-tax benefit of a 401(k), and could also push you, as a retiree, into a higher tax bracket, subjecting more Social Security benefits to taxes.

2. Many 401(k) Plans Offer Investors Limited Options. While some 401(k) plans are excellent, many others offer investors painfully limited options. If these options are not just limited, but also include problematic mutual funds (load funds, expensive funds, under-performers), then you might be better off steering clear of your employer sponsored retirement plan (except for up to the employer match), and investing in a Roth IRA or in a regular taxable account.

But 401(k) Accounts Also Have Some Important Benefits

1. Employer Match. If your employer matches your contributions to your retirement plan, you should definitely contribute up to that amount, to take full advantage of the essentially free money your employer is offering you.

2. Pre-tax Savings. Unlike other retirement vehicles, 401(k) accounts allow you to invest pre-tax dollars, which saves you a lot of money, especially in the higher tax brackets.

3. Automatic Deductions. This is a big one. Since you make your elections once a year, and then the money flows directly from your paycheck to your 401(k) account, you don’t face the temptation of spending the money instead of saving it. This is a great way to ensure you actually save.

4. Cheap Index Funds. While 401(k) plans tend to offer limited investing choices, many of these plans do offer a variety of cheap, no-load index funds. For the vast majority of investors, these funds are more than adequate.

The Bottom Line

While 401(k) plans are not perfect investment vehicles, they provide too many benefits to pass up. If you’re eligible for a Roth IRA, your best course of action is likely to take advantage of any employer match to your 401(k), then max out your Roth IRA, then go back to your 401(k) and max it out. If you still have money left to invest after all that (lucky you!), you should invest the rest in a regular, taxable account.

If you’re not eligible for a Roth IRA account, my personal belief (and what my husband and I do) is you should max out your 401(k) account, and then put the rest in a regular, taxable account. Pre-tax investing, coupled with an employer match and a likely lower tax bracket at retirement, all combine to make 401(k) plans a great investment vehicle, despite their drawbacks.

Are you maxing out your 401(k) account?

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  • J says:

    Sound advice. A big problem with maxing out your 401k first and foremost, as many financial advisers recommend for some strange reason, is liquidity. How many people need or want to buy a new home right now, the market has dropped to where it is affordable, and yet they have little or no liquid cash because they’ve taken the silly advice to max out their 401k first and the drop in the market means they lost equity in their homes so they don’t have a 20% down payment with all their money tied up in their 401k. Similar opportunities come along to startup your own business–venture that can be faaaar greater investments yielding thousands of percent return in a matter of 5 – 10 years–yet you need liquid cash. A credit score and a big 401k account can only get you so far.

    • Roger @ The Chicago Financial Planner says:

      @J as one of those financial advisors who encourages his clients and others to contribute as much as possible to their retirement accounts I would encourage balance. By this I mean that I wouldn’t encourage someone to fund their retirement accounts to the point where there is no liquidity available. On the other hand, funding retirement takes A LOT of money, the earlier one can start on this process and the more one can save the better. Real Estate or a business venture may seem like a great investment (and in many instances this is the case) but I’m also very leery about over investing in either, especially one’s retirement funds. Balance is financial planning and investing is generally a great course of action.

  • jeff says:

    I am close to retiring and have always contributed heavy in 401K but if I had it all to do over I would have just bought minted gold coins. Once every couple of paychecks or whatever it works out to and not let the government know so they could never tax you. Seems possible, can they track the transactions ? Anyway, its simple solid investment you control and in the end you could stack them up like poker chips and give them to whoever you want. No lawyers, tax man, financial experts etc.

  • Take your money & run... says:

    The truth about saving money was right in front of our faces over Sixty years ago when Frank Capra’s George Bailey character pulled back the entire Banking curtain with 4 simple words: “The money’s not here.”
    Sure it was a romantic yarn spun with the idea that the money is in other people’s property, and thus is helping others.
    But the fact is, if you want your money it isn’t really there.
    Just ask MF Global customers who had CASH brokerage accounts looted with a keystroke. Contrary to media & government spin to make dumb Americans think they lost money in some “Futures” or “Leveraging” collapse, they literally had bank robbers from inside the company empty their accounts, then were told by CME Group, sorry Charlie we don’t actually cover your money. Now if there were really 1.x Billion dollars “there” it would have taken a freight train to move it, or at least some big trucks. But it was just numbers on a computer screen, worth no more than the Federal Reserve private IOUs the Treasury prints.
    Your accounts are only worth something if they say they are.
    Do you still want to play a shell game with your hard earned money, just because your employer (claims) they will match up to X % of your contribution (which I discovered isn’t real money they are putting in, just commission kickbacks from the brokerages), then be locked into a few pre-determined funds the broker wants you to invest in?
    Did people already forget many American’s 401(k)s were WIPED OUT in the 08/09 crash.

    A bird in the hand…

  • B. Thomas says:

    Let’s consider another point of view: The statement that you will likely be in a lower tax bracket when you retire has been stated so often that it is taken as truth. But… it is likely a bit of smoke and mirrors.

    Does anyone really think that taxes will be lower in 30 years, or 25 years, or 20 years? You may be in a lower tax bracket due to a retirement income that is lower then your future pre-retirement income, but, not lower than current taxes. Furthermore, retirement income is, for the most part, fixed income. The ability to pay taxes become difficult whe working with fixed income.

    Now, for the eye opener: Let’s say you are contributing $10,000 annually into your 401k. In the ~20% tax bracket you are saving $2,000 annually in taxes. For the sake of keeping it simple, lets say you have stayed in the same tax bracket and continued with the $10,000 for 30 working years. You would have put away $300,000 of which, $60,000 was not yet taxed ($2,000 x 30). Big savings gift from Uncle Sam.

    If your average annual rate of return was 7.3% you would have accumulated $1,000,000 in 30 years. Remember, you saved $60,000 in taxes.

    Now, you are ready to retire: If you take a 5% distribution from the $1,000,000 nestegg, your 401k retirement income would be $50,000 annually. Lets assume you enjoy retirement for a good 30 years. Lets also assume the tax rate is still 20% (not likely). As such, Uncle Sam is taking his pound of flesh at the rate of $10,000 annually. Over 30 years, you have now paid back $300,000 in taxes. Upon your death your daughter inherits the $1,000,000. She now has a tax liability of 35% based on today’s rates. Her check to the government is $350,000. Adding your daughter’s tax to the taxes you paid, Uncle Sam has taken back a total of $650,000. A $650,000 return on a $60,000 investment. Not a bad hat trick, or the biggest scam ever fostered on the American public. The 401k makes B. Madoff look like a piker.

    Maxing out your employer’s match is a good thing. Maxing out your 401k is not so good.

    One last point: The money going in is not tax free, it is tax deferred. Big difference.

    There are other options that trump the 401k and even the Roth. Maybe your advisor may be aware of what they are.

  • Udayan Chattopadhyay says:

    One cannot truly make a blanket statement regarding where and how much money people should keep because individual situations vary greatly. I for one try to keep my investments as liquid as possible and what I tend to do is match the employer contribution for 401k and keep the remaining in a roth IRA. But hey… that’s just me 🙂

  • Norker says:

    And who knows how much longer capital gains rates will be lower than general income rates. If Congress finally gets around to serious tax reform, its not unlikely that we’ll see a simpler set of rate brackets applied to all sources of income equally, with few deductions. I’d like to see no deductions, but I don’t think Congress has the stomach to go that far yet.

  • justme says:

    A 401K is a great vehicle for saving money. You may not even miss the contributions. And after years of compounding, you’ll likely have saved up a lot more than you expected. Granted, there are going to be bad years (like 2008 and 2009), but there are also good years (the second have of 2010) and right now. If your employer offers a match, at least contribute up to the employer match. I’d recommend contributing up to the 401k max per year if you can, and if you have money left over, contribute it into a Roth IRA.

    I think the biggest problem with a 401k is that many people don’t understand how to invest. I have to admit, I didn’t either initially. If you’re not sure, look to index or target funds. Some 401ks may even offer automated investing based on your age and investing style. If you can, do some research. Try to diversify your investments.

    It’s never too late to start investing for your retirement. But the sooner you start, the better off you’ll be.

  • Finance & Tax Guy says:

    It is hard to pass up free money from you employer. The benefit of an employer match trumps many of the flaws, such as limited options in the plans. Your employers 401k is almost always the best place to start when you are putting dollars aside for retirement.

  • Zellie says:

    I have no faith in the 401k vehicle, I think they will tank.

  • KM says:

    I don’t have access to a 401k yet (but I will when I start working full time in May), but I am currently contributing to a Roth IRA, some regular investments, and whole life insurance, which will also grow quite well. I am hoping to max out at least one of them when I work full time.

  • marci says:

    No, I’m not. As I don’t make enough literally to max it out… My gross yearly would be under the $16,500 now. But… I do take advantage of the employer match in full 3%, and I do put a total of 25% of my gross into the 401K. Like you said, if it’s not in the paycheck, it’s easy to save it. Pay yourself first.

    • Sean says:

      Smart move. Keep it up and throw any extra you get into it. You sound like the kind of person who in ten years will be making a lot more than you do now and then you’ll never feel this lost income. Keep it up, it’ll reap a lot later.

  • Ginger says:

    For those will very low incomes, a Roth IRA maybe better than a 401k/403b. My fiance makes $26000 and pays very little in taxes. He is a graduate student and therefore expects his wage to increase, which in turn increases his tax liability, therefore he has chosen a Roth for now and will use the 403b later.

  • Aamer says:

    For those not sold on the idea of 401k, there is a Roth 401k option being offered now (As Roger mentioned). Offers the same benefits of company match but is taxable on the front end.

    • Roger Wohlner says:

      Aamer, remember that the Roth 401(k) is optional for employers, they have to elect it. For example I advise a number of 401(k) plans and just one has made this election.

  • Roger Wohlner says:

    Good post and all valid points. At the end of the day, unless their plan is beyond terrible, it is generally a good idea for most people to contribute as much as they can to their 401(k) plan as it is forced savings. On paper contributing to an IRA or some other vehicle in lieu of a not so good 401(k) makes sense, the reality is that many folks lack the discipline to actually do this.

    Also more and more plans are offering a Roth option.

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