Should You Max Out Your 401k?

Personal finance wisdom dictates that everyone should save as much money as they can towards their retirement. Many experts state that the more funds an individual allocates to their savings, the better it is for them when they retire.

However, that is not always the case, especially knowing that every individual’s financial situation is different. In this article, we will go over what a 401(k) is, how to max out a 401(k), and what employees should consider before maxing out their 401(k).

Keep reading until the end, as we will also go over how employees can get a 401(k) max and adopt a dynamic approach to savings. Let’s get started!

What Is a 401(k)?

A 401(k) is a tax-advantaged account sponsored by the employer on behalf of their employees. It is a great incentive to keep the staff motivated and happy to work for the company, resulting in lower costs associated with recruitment and employee onboarding.

In this retirement account, an employee makes contributions from their compensation annually to help save for the time when they retire. Depending on the plan, an employer may match part or all of that contribution.

What Does Maxing out 401(k) Mean?

There are contribution limits on 401(k) for the employee and employer set by the Internal Revenue Service (IRS).

Maxing out a 401(k) refers to contributing the maximum amount of money prescribed by the law every year to enjoy the benefits of compounding and appreciating assets over time.

It could also refer to making contributions up to an employer’s percentage match.

What Are the Contribution Limits on a 401(k)?

The contribution limits on a 401(k) set by the IRS in 2023 is $23,500 annually. There is an additional catch-up contribution of $7,500 for individuals who are 50 years of age or older. This brings the annual maximum contribution to $30,000.

What Should Employees Consider Before Maxing out Their 401(k)?

Maxing out 401(k)

Maxing out a 401(k) may not always be a wise decision. Here are the four things an employee should consider before maxing out their 401(k):

Make a List of Their Non-retirement Goals

We understand how important it is to save cash for retirement, and most financial planners advise their clients to max out their 401(k) to have sufficient money for when they retire. However, that may not always be a wise decision.

An individual may have high-interest debt, or they may not have enough rainy-day money for emergencies. Perhaps, they don’t have health insurance or even a life insurance policy.

It’s essential for everyone to consider their non-retirement goals before they decide to max out their 401(k). The key is to look at the bigger picture.

Sure, one must have enough money kept aside for retirement, but is it worth sacrificing a health insurance plan or an emergency fund?

Life can be uncertain and, in most cases, unpredictable. A person may incur an unexpected expense, and if they max out their 401(k), they may not have enough money to pay for it.

We recommend balancing the act of keeping some money aside as retirement savings and the rest to accomplish non-retirement goals.

Find the Right Balance Between Saving and Spending

According to a 2022 Bankrate survey, 55% of Americans are behind on their retirement savings. Hearing that can be depressing, and advisors use these such data to encourage individuals to max out their 401(k).

Vanguard, an investment firm, conducted a study on retirement savings and found that the average 401(k) balance for Americans between the ages of 25 and 34 was only $14,000. This is much lower than the savings guidelines a financial firm, Fidelity, recommends everyone should follow.

According to Fidelity, an American should have saved the equivalent of their salary by the time they’re 30, triple that amount when they’re 40, and 10 times their compensation when they reach the age of 67. By these standards, those individuals who earn $15 an hour must have $30,000 saved on their 30th birthday. That’s absolutely bonkers, especially considering the state of inflation and economic uncertainty.

Any individual reading these types of retirement savings guidelines might start to stress, but we’re here to bring calm to the situation. These goals are not a one-size-fits-all solution. Although we encourage our readers to save, maxing out their 401(k) may not seem like a realistic thing to do.

It’s all about finding the right balance between tomorrow and today. If people start saving later on in their life, they may have a lot of catching up to do to ensure that they have sufficient funds when they retire. However, if individuals start to save earlier, they may need to tap into their employer contributions (there may be a 10% penalty) to pay for unexpected expenses.

The key is to have enough money to cover one’s current living expenses and to keep some aside for a rainy day before transferring the rest to their retirement account.

Everyone has different needs, and it’s crucial that they consider those before deciding to max out on their 401(k).

Explore Other Investment Options

When an employee has enough money to set aside for their employer-sponsored retirement plan, we recommend that they consider other investment options as well.

Even though it is convenient for employees to funnel the extra money into their 401(k)s, it may not always be the best option for them.

We did some research into the matter and found out that an employer-sponsored retirement plan may have high fees, which can adversely affect the employee financially.

If an employer-sponsored retirement account has high fees, it’s important for the employee to explore other investment options. A traditional or Roth IRA may be an excellent option for everyone looking to avoid paying such costs and increase their savings. If an individual still has enough money left after maxing out the IRA, they should consider moving the spare cash into the 401(k).

Now the question boils down to whether an individual should choose a traditional IRA over a Roth individual retirement account. The main difference between the two are taxes. Here’s what we mean by that:

  • In a traditional IRA, an investor funds the account with pre-tax dollars, meaning that they will have to pay an income tax when they retire.
  • On the other hand, contributions to the Roth IRA are already taxed, which means that the investor does not have to pay any taxes upon retirement, as they’ve already invested after-tax dollars.

The key takeaway here is that employees should max out their 401(k) if they can max out their IRA without jeopardizing their non-retirement goals.

According to the IRS, the contribution limits for 2023 for a traditional and Roth IRA are $6,500 for those below 50 years of age and $7,500 for those who are 50 years or older.

Consult with a Financial Advisor

Consult with a Financial Advisor

There are many things that an individual must consider before maxing out their 401(k), such as the contribution limit and employer matching contributions. They may have other financial needs, or there may be better investment options out there for them.

If an individual is not comfortable in making a financial decision, we recommend that they reach out to an experienced advisor.

There are different types of financial planners, and they may specialize in a particular field. It’s essential to look out for an advisor who is also a fiduciary. What this means is that they will look out for the client’s best interests rather than their own.

By discussing the financial and retirement goals with a certified financial advisor, an individual may be able to see the bigger picture, understand the available options, and make an informed decision.

However, personalized investment management comes at a fee that the investor should be ready to pay.

Should You Max out Your 401k?

This question is tricky, as there is no easy answer to it. We’ve gone over the four considerations that an individual must keep in mind before they decide to max out their 401(k).

In short, if a person is rolling in cash and is in a high tax bracket, they may want to fund their employer-sponsored retirement account according to the maximum contribution limits prescribed by the IRS.

When Should an Employee Avoid Maxing out Their 401(k)?

We’ve compiled a few situations where it may not be suitable for an individual to funnel most of their money into an employer-sponsored retirement account. Some of these include the following:

If They Job-hop a Lot

Maxing out a 401(k) may not be a great option for those people who job-hop often. This is because some employer-sponsored retirement plans may have a vesting period.

A vesting period is the maximum amount of time an employee must wait before they can access their employer’s matching contributions.

Some employers allow their employees to withdraw the 401(k) immediately, while others may have specific terms (years of service) that the employee must fulfill before they can tap into their retirement savings.

If an employer has a vesting schedule, maxing out a 401(k) may not be a wise idea for individuals who might be planning to join another company in the near future.

If They Don’t Have a Decent Cash Buffer

Although maxing out a 401(k) seems like one of the noble financial goals, it’s essential to understand that if an individual is struggling to have a decent cash buffer, they may want to consider lower contributions to their employer-sponsored retirement account.

If They Have Other Financial Obligations

Some people may be ready to tie the knot, while others might need a car to make it easy to travel to work every day. Everyone has their own financial obligations that they must fulfill before they can consider maxing out their 401(k) contributions.

We recommend that all of our readers take care of the following financial goals before they decide to max out their 401(k):

  • Establish an emergency or a rainy day fund that can cover three to six months of living expenses. There has been a lot of economic instability in recent years, and the future remains unpredictable. Anything can happen, which is why it is crucial for everyone to have enough cash stashed away for the times when they need it the most.
  • Pay off high-interest debt first before maxing out 401(k). A debt with a high-interest rate can place an individual in a bad financial situation if they don’t pay it off as soon as possible. This is because the interest will continue to pile on, which will keep increasing the repayment amount.
  • Invest in the right insurance plan. Whether it is a car accident or a medical emergency, having the right insurance can help provide coverage. We recommend reaching out to insurers to discuss life and medical insurance policies.

How Can Employees Get the Full 401(k) Match?

Most employers set limits on the maximum amount they may contribute to the employee’s 401(k), which is often lower than the IRS’s contribution limits.

A company, for example, may match up to 3% or 6% of the employee’s salary for the employer-sponsored retirement account.

If an employee cannot max out their 401(k) up to the contribution limit set by the IRS, they should at least aim to contribute up to the employer’s matching contribution limit each year.

Adopt a Dynamic Approach to 401(k) Savings

An employer-sponsored retirement plan provides employees with a lot of flexibility when it comes to making contributions. Instead of aiming for an employer match, we recommend that individuals adopt a dynamic approach to 401(k) savings.

The key is to save more, have financial flexibility, and reduce taxes over the long run. To do that, individuals should increase their deferral amount bit by bit every year. It may seem like a hassle but trust us; the process is very simple. In fact, everything is completely automated.

By using a common feature known as the “auto-increase,” employees can increase their contributions yearly when they receive their increments. Every time they receive a pay rise, the deferral amount will increase, allowing the employee to save more as time goes by.

Final Thoughts: Is a 401(k) Worth It Anymore?

We understand how challenging it can be to save for retirement, and many employees might stress over finding ways to max out their 401(k) retirement accounts. It’s important to be realistic and assess one’s financial goals before making any decisions.

Many financial advisors may be in favor of allocating 10% or 20% of one’s income to 401(k). We’re here to emphasize that it’s okay to fall behind on these types of recommendations, as every person’s financial needs are different.

Everyone should consider taking a step back to make a financial plan. They should go over their non-retirement goals and create a realistic contribution schedule with which they’re comfortable with. The least they can do is qualify for their employer match, as matching contributions are essentially free money!

Frequently Asked Questions

What Should an Employee Consider Before Investing in an IRA?

There are a few things that an individual must consider before investing in 401(k) alternatives, such as a traditional or Roth IRA. Some of these include reviewing employer-sponsored retirement account fees and the avenues where the funds get invested. This will help them determine whether opening an IRA is the right move for them.

What Happens If an Employee Over Contributes to Their 401(k)?

Under the IRS guidelines, any employee that contributes over the limits to their 401(k) must report it using the 1099-R form.

The IRS will remove the excess funds, and since that is technically considered as “withdrawals,” the employee may also face a 10% penalty if they’re under the age of 59½.

Depending on when the excess funds get returned, the individual may also get taxed again.

Can an Employee Have Multiple 401(k)s?

It is possible for an employee to have multiple 401(k) accounts, depending on how many times they’ve switched their jobs.

However, since contributions are only made through payroll deductions, an individual cannot contribute to an inactive account sponsored by their former employer.

In some cases, an individual may be juggling two jobs, with both of them offering a 401(k). They may contribute to both the active retirement accounts while staying within the contribution limits set by the IRS.

How Does a 401(k) Help Reduce an Employee’s Tax Bill?

It may be difficult for many people to understand how a 401(k) can help reduce an employee’s tax bill, so let’s break it down into easy-to-digest information.

Let’s assume that an employee is paying a 24% income tax on their earnings. In this situation, they can defer paying a certain amount of these taxes by contributing up to $22,500 to their 401(k).

By contributing $22,500 to their 401(k), the employee is reducing their taxable earnings, which means that they’re saving $5,400 ($22,500 x 24%) in taxes. However, they will have to pay income tax once they withdraw the amount from their retirement account.

How Can an Employee Max out Their 401(k)?

The quickest way for an employee to max out their 401(k) is by contributing greater amounts every pay period, more than they would need to reach the maximum contribution limit in 12 months.