Should You Max Out Your 401(k)? It Depends.

It’s common wisdom that you should contribute as much money as possible toward your retirement. But maxing out a 401(k) account is not always the best retirement planning move. Learn when it does, and doesn’t, make sense for your financial future. 

What is a 401(k)? 

A 401(k) is a retirement savings plan offered by many American employers. The plans allow workers to defer a certain portion of their wages into a retirement account, which they can then invest for the future. The plans come with tax benefits, and sometimes an employer match. 401(k)s are named after a section of the U.S. Internal Revenue Code (IRC). 

With all these benefits, does it make financial sense to max out your 401(k)? The answer? It depends.  

If you participate in an employer-sponsored 401(k), you can earn on average in the range of 50 and 70 basis points a year in extra potential return due to the tax-free growth. That means you can get 0.5% to 0.7% in extra potential return each year to lock up your capital until you are 59½. For example, let’s assume that you pay 0.85% per year in fees to get a diversified portfolio in a taxable account, then paying anything more than 1.35% (0.5% + 0.85%) to 1.55% (0.7% + 0.85%) in your 401(k) would eliminate its long-term tax benefit.  

But what if your 401(k) provider has alarming fees for both the funds within the plan and the fund administration? Those fees add up and, in some cases, can eat away the benefits of a 401(k). A 2015 academic study found that in 1 of about every 6 plans, the fees were so high that they “consume the tax benefits of investing in a 401(k) for a young employee.”¹  

Irrespective of the high fees, the first step is always to invest up to the employer match, which is equivalent to a 100% return on your investment. Once you’ve done that, if you don’t have a competitive plan option you could open an individual account or an IRA (or both) through a fiduciary that has better options such as low-cost index funds and professional investment management.  

Another consideration is flexibility, especially if you’re going to retire early. If you are a high earner and plan to retire at age 50, you have a nine-year gap before you can take distributions without a 10% early distribution tax on top of the income tax you would owe. Or if you would like to save up a down payment on a house, having an additional $50,000 or $100,000 outside of a retirement account can make it easier to afford. 

And when it comes to investment options, 401(k) plans often have a limited pool compared to other investments, such as IRAs or taxable accounts. As a result, you may not have access to the same asset classes, and you might have to pay more for them as well. If all the funds in your employer’s 401(k) plan have high expense ratios, then you have no choice but to pay high fees – which correlates to lower returns. 

Maxing out a 401(k) isn’t the best decision for everyone and it’s wise to weigh the pros and cons. If you are unable to manage your assets or don’t have a good advisor, it makes sense to keep buying into your 401(k). Positive outcomes are the result of the automatic nature of a plan. But if you are a bit more disciplined or have a good wealth advisor, the flexibility of using an individual account for a portion of your wealth can make financial sense.  

If you need additional information, contact your wealth advisor. And if you’re not a client, let’s talk. 

¹ Yale Law Journal, March 1, 2015: The Current Legal and Regulatory Regime Is Ill-Equipped to Address Excessive Fees, Ayres & Curtis