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If you can max out your 401(k) you definitely should, right?
Not always. There are a few things (five, to be specific) you should consider before doing so, and we’ll walk through exactly what they are in the article below.
But first, we’ll highlight what a 401(k) is for those not 100% familiar with this amazing retirement tool.
A 401(k) is a type of investment account that is offered by your employer.
With a 401(k), you designate a percent of your income (paycheck) that you want to contribute and it is automatically deducted and invested for you (based on your pre-selected investment vehicles).
The biggest benefit of a 401(k) is that your money is taken from your paycheck pre-tax. Like most things, this is best explained through an example.
Say you normally get taxed 30% on your $50,000 income and want to invest 10% of your income.
With a 401(k): You would contribute $5,000 ($50,000 x 10%). You get to invest the money before paying the 30% tax!
With a brokerage account: You would only contribute $3,500 ($50,000 x 70% x 10%). You first have to pay taxes before you can invest.
On top of this huge tax break, sometimes your employer will provide a 401(k) match. This is when they also contribute to your 401(k). The most common practice is a company matching 50% of the first 6% you contribute (though this usually varies by company). Here are a couple examples to help illustrate the 50% match up to 6%:
- Example 1: You contribute 3%, employer contributes 1.5%. Total = 4.5%.
- Example 2: You contribute 6%, employer contributes 3%. Total = 9%.
- Example 3: You contribute 9%, employer contributes 3%. Total = 12%.
You should always max out your employer contributions (at least getting to example 2), this is free money!
With all of that said, there are a few rules that apply to your 401(k) to be aware of as well:
- Max Contributions: The max contribution for any individual is $19,000 annually, while the max contribution for the individual + employer is $56,000 annually.
- Withdrawal Rules: Money withdrawn before age 59.5 is subject to a 10% additional tax.
- Mandatory Withdrawals: Similar to Traditional IRAs, you must start withdrawing from the plan at age 70.5 to avoid penalties.
Checklist: What to Do Before You Max Out Your 401(k)
Now you’re eager to max out your 401(k) to take advantage of those great tax benefits… great!
However, before diving in head first, there are a few (five) personal finance basics you need to take care of before you max out your 401k.
1. Pay Off Short Term Debt
Short term debt is what I will label as “bad debt”. Usually it’s either unintended (like credit card debt) or has a high interest rate (like credit card debt and/or student loan debt).
These are debts you usually want to get paid before maxing out your 401k. Specifically, they could include:
- Credit Card Debt
- Student Loan Debt
- Bank loans
- Car loans (sometimes)
This does not include debt like mortgages. While you can decide to prioritize your mortgage over a 401(k), it’s not necessary.
2. Get Insurance
This one is easy: get necessary insurance before investing.
This could include anything like car, home, medical, and/or life insurance. Don’t get caught unprepared for an emergency, because your 401(k) should not be your lifeline to help with short term issues that arise.
Speaking of emergencies…
3. Set Up an Emergency Fund
Most people recommend 3-6 months saved up in a liquid account. However, you should do whatever helps you sleep at night knowing you have money saved for an emergency (getting laid off, a big medical bill, etc.).
A high yield savings account is the best place to store this fund, in my opinion.
4. Consider Other Tax-Advantaged Accounts
Depending on your income and where you are at in life, it may be wise to invest in other tax advantaged accounts before you max out your 401(k).
Here are some accounts to consider:
- Roth IRA: A Roth IRA is, in simple terms, is the opposite of a 401(k). Instead of contributing pre-tax money, you contribute post-tax money but do not pay taxes when you withdraw your earnings. A Roth IRA can be useful for someone in a low tax bracket now who thinks they will be in a higher tax bracket when they retire.
- Health Savings Account (HSA): A health savings account is a unique account that can be useful for both retirement savings and medical expenses.
- 529 College Savings Plan: If you have kids and want to pay for their higher education, you could consider investing in a college plan for them as well.
5. Ensure You Have Enough Saved for Near-Term Goals
Last thing to consider is: can you pay the bills?
It’s a lot easier for someone making $100,000 a year to max our their 401k (19% of paycheck) compared to someone making $40,000 a year (nearly 50% of their income).
Obviously, you need to make sure you have enough money left on your paycheck to pay the bills.
Then, you can assess if you have enough money for major short term expenses or goals, like having a baby or making a down payment. These short term goals and expenses will likely come before you have penalty-free access to your 401(k).
Why Maxing out Your 401(k) Is a Good Decision
Assuming you have squared away all five considerations above, maxing out your 401(k) can be a great next step for you! It’s a better decision than keeping money hoarded away in a savings account, or even in a different brokerage account (that is not tax advantaged).
Here are two examples to help illustrate this point, with the following assumptions for both:
- Income: $50,000
- Total Tax Rate: 25%
- Market Growth Rate: 7%
- Timeline: 40 years
Example 1: Investing $5,000
In the example where someone wants to invest $5,000, whether they choose a brokerage account or 401k they will net the same amount of money at the end of their investing lifespan.
Both will have approximately $1 million dollars after 40 years.
However, the person investing in the 401(k) would have enjoyed a $33,750 after-tax income ever year. While the person investing in a brokerage account would have only had $32,500.
That is $1,250 less than the person investing in a 401(k).
How many of you would like an extra thousand dollars ever year to spend?!
Example 2: Investing 10%
Now, let’s assume both people want to invest 10% of their income rather than a flat $5,000.
This time, both individuals would enjoy an after tax income of about $33,750.
However, the individual investing in a brokerage is only investing $3,750 per year (after paying taxes). While the person with a 401(k) is investing $5,000 a year (investing 10% before paying taxes).
At the end of 40 years, the 401(k) investor would have close to $1 million, while the brokerage account investor would have only $750,000.
A quarter of a million dollars difference!
This is why, if you can, choosing your 401(k) over non-tax advantaged investment accounts is a huge benefit over the long run.
How to Choose the Right 401(k) Investment Vehicles
Unfortunately, 401(k)s do not always have a wide variety of low cost index funds like Vanguard or Charles Schwab.
Here are some things to look for when picking your 401(k) investments:
- Diversification: Having the right mix of bonds vs stocks is a good first step. From there, you can decide if one stock fund will do, or if you want to branch out into a couple. This article on 3 Fund Portfolios can help guide your decision.
- Low Cost: As with all investing, finding low cost funds is extremely important. With some 401(k) providers, you may have to settle for slightly higher expense ratios, but you should still aim to find the lowest available.
Need further help analyzing your 401(k) situation?