Disclaimer: These are my opinions.
Should you max out your 401k? It’s an intimidating question.
As a Chartered Financial Analyst who retired from Financial Services at age 42 I have seen “experts” give a lot of bad advice or avoid giving good advice. There are so many unqualified people on the internet and YouTube claim to be experts. There are also so many Financial Advisors who are dissuaded from giving advice on a client assets held away from the Financial Advisor.
My career was in the home office of two very large brokerage firms. My roles were generally around designing or approving which investment products and tools Financial Advisors had access to. I even managed an Investment Risk team for several years. I also spent several years helping build Managed Account Programs.
Bottom-line: I understand how Financial Advisors are dissuaded from giving advice on 401ks. (That is also one reason why I endorse Personal Capital. They are willing to give advice on your 401k)
This post is my chance to provide unbiased advice as someone who knows the shortcomings of all of the biased, unqualified, and/or and inexperienced advice on 401ks and personal finance in general. I am giving general advice and opinions here. I’m also giving my personal experience. Your situation is unique to you, make decisions accordingly.
What Does It Mean To Max Out A 401k?
Before jumping into why you should max out your 401k, let’s step back. If you are under 50, you are allowed to contribute up to $20,500 to your 401k. This does not include employer contributions. It is also the 2022 IRS contribution limit. There are other nuances and disclaimers to this, but for a majority of the people reading focus on contributing $20,500 a year (if married you each can for a total of $41,000). This article is going to focus on those under age 50.
Why Max Out your 401k Retirement Plan?
401k plans lower your taxable income by your contribution amount and defers taxes on capital gains. Both are wonderful tax advantages to help you save for retirement.
401ks are explained in great detail elsewhere. Since there is nearly $7 Trillion(!) in 401ks, it is no wonder that there is no shortage of information and opinions on 401ks. The days of pension plans have all but passed us by.
The basic reason to contribute the maximum is because the more you invest, the more you will likely have later. To retire, you need more later. 401k’s are a tax deferred vehicle. They are not tax-free. Instead they are tax deferred retirement savings account.
So you are essentially able to invest an additional amount each paycheck that would otherwise go to taxes, and then pay taxes later.
If you max out and contribute $20,500 a year and your tax bracket is 22% then you are investing $4,510 more that year than you otherwise would have paid in taxes. If your boss offered you a $4k raise would you say no? Of course not, so don’t say no to saving that amount in taxes. Compound that over the years and you have a large nest egg.
Why Shouldn’t I Max Out My 401k?
There is no shortage of debates on whether or not to max out your employee contributions. If I was solely interested in google traffic and you sharing this post with your friends (please do) I would write out a debate. I’m not doing that, others can. Instead I will lay out what allowed me to retire at 42, and you can decide what will work for you.
Unfortunately many Financial advisors will not actively recommend maxing out your 401k. They will try to steer you to contribute to IRAs. IRAs get them paid, 401ks don’t.
It is my opinion (from being in the meetings deciding these things at two of the largest financial services firms) that financial advisors are generally dissuaded from giving investment advice on 401k plans. In several different roles I was a part of the work streams making decisions about whether or not to offer 401k advice.
This is something that really bothered me in my career. The large firms were afraid to give advice on accounts they were not custodian over.
In other words, Financial Advisors tend to only give advice on your brokerage account. This is a flaw in the system. Instead they are incented to recommend a Roth IRA or traditional IRA instead of coaching you to maxing out your 401k. So why shouldn’t you max out your 401k? Because you are listening to advice that is in your best interest.
It’s not entirely the Brokerage Firms fault, it’s also a function of regulators making it challenging for firms to give advice on assets held elsewhere, but that’s a different story.
But there are instances where it makes sense not to max out your 401k. More specifically: If you do not have an emergency fund then don’t max out your 401k yet. Many people will tell you a different number to have in your emergency savings account.
You know your number, people that do not know your situation don’t. It isn’t based off of time. e.g. “6 months” is arbitrary. Its based off of how certain your income and expenses are. No one on YouTube can tell you the likelihood that you will have a job loss or an unexpected expense. The amount of my emergency fund has always varied with my spending habits and the certainty of my income.
Determine your own minimum emergency fund, and set that amount aside before you max out your 401k.
Max Out Your 401k As Early As You Possibly Can
If you can contribute as much as possible as early as possible then the snowball grows quickly. Then you can stop contributing when you retire early and let the investment grow.
As an example: An asset base of $500k at age 45 invested for 15 years achieving a 5% return will become $1M+.
But $500k by age 40 may seem intimidating. It doesn’t need to be. Put as much as you possibly can into your 401k. Do not put as much as you can to feel like you are putting a lot in, I mean put the most you can in. You are paying future you. That is how I looked at retirement and my 401k.
To me, that $20k a year was not mine. It was future me’s money. If I didn’t max out my 401k then I was stealing from future me. I don’t steal, especially from future me.
Should You Max Out Your 401k, Or Just Up To The Employer’s Match
I said I was going to avoid this debate, but I will take a stance on it. Yes. Max out your 401k. Many people give advice for employees to contribute up to the employer’s match. But doing that limits the value of the 401k tax deference.
Should I Max Out 401k Or Pay Off High-Interest Debt?
If you have high-interest credit card debt, then focus on paying it down as aggressively as possible, and stop adding to it. There is not a magical formula to what percent of every dollar you should put towards debt vs your retirement plan. There are so many pieces of advice on what to do here, but the real advice is do what mentally works for you.
If you can take emotion out of the equation, then it’s just a math problem comparing interest rates vs rate of return of your 401k investment options. But let’s not fool ourselves. Paying down debt is a mindset shift.
If I Am Married, Should Both Of Us Max Out Your 401ks?
If you are married, then you have an additional opportunity. I was maxing out my 401k. My wife was making $50k pretax in ordinary income a year. We decided we would max out hers too. That was a big mindset shift in our house. It meant she was putting ~$20k of her $50k into a retirement account. That meant her paychecks after tax were very small. It psychologically hurt.
But what it allowed us to save $40k a year into our 401ks plus get the company matches. It also allowed us avoid ~$12k in taxes.
Would we rather have used that money on trips, buying and RV, or buying a Tesla? Of course. We focused on saving now so we could have financial independence later. We also focused on satisfice. This is the idea that you buy what makes you happy, but no more than that.
We only did this for a few years. Maybe two. I didn’t think about it earlier in our relationship. She walked away from her job a couple years ago once our twins were born.
Should I Max Out My 401k Or Pay Off Mortgage?
Your 401k should be a priority. Funding it creates a snowball that compounds over time. I look at it this way, if my salary is 80k, then I actually make $49.500 before taxes. To me that means I can only buy a house based off of an income of 60k a year, not 80k.
This is true no matter what your income is (as long as you can cover basic needs expenses, which most studies say is $70k income for a household).
If you haven’t bought a house yet, buy a less expensive house.
Treat the 401k contribution as a liability, just like taxes. It isn’t your money, it is future you’s money.
But Not Everyone Has 401ks
Not everyone has access to a 401k. Many employers do not offer them. Many of my readers are self employed. Keep in mind, that a 401k is just one type of tax deferred vehicle. There are many. There are actually many different flavors of IRAs (Roth, Traditional, SEP, SIMPLE, and on and on). A few of these are great for small businesses.
This post is focused on 401k’s because that’s what I had access to.
The point is the same regardless of vehicle. One way to retire early is to invest as much as you can in a tax deferred account. Make it hurt because that is future you’s money. You’ll be glad you have those assets later.
I Have Maxed Out My 401k, Now What?
This is where things really get fun. After you have maxed out your 401k, consider other tax deferred accounts. Health Savings Accounts (aka HSA), Individual Retirement Accounts (aka IRAs), College Saving Plans (e.g. 529 plans) are all wonderful places to contribute.
Maxing out your 401k is critical. After you are able to do that these other tax deferred accounts become increasingly challenging to max out depending on your income and spending. Look for a future article from me on what order to contribute to these if you have the income to do so.
Maxing Out A 410k And Retiring Early
My approach: Accumulate and invest for phase 1 of retirement (age 40-60, or whatever for you) and also invest for phase 2 of retirement (age 60 until death). Staggering it this way gives you liquidity for phase 1, and the benefits of tax deferred investing for phase 2. But you know you, I don’t. Make decisions that make sense for you. There are many approaches that work.
My Approach To Retiring Early: 2 Phases
Everyone’s financial goals are different. If yours is to retire early, then let me share what worked for me. My approach to Financial Independence Retire Early was breaking my retirements into two phases.
Phase 1 for me was to accumulate enough in a taxable investment account to last me from age 40-something through 60ish. I invested in buying single family rental homes (with $800 out of pocket) in my early 20s. Then over the following two decades tenants paid them off.
Phase 2 is saving and investing enough to carry you from age 60 something through death. To retire early you also need to have income and assets to carry you to that age. Everyone focuses on age 60 on. I focused on both age 60 on AND age 40s to 60. Planning and investing for it starts today. It starts immediately. For me it started at my first real job after college at age 21.
If you retire early then your 401k should continue to grow even when you aren’t contributing to it. Just don’t withdrawal from it early. The penalties and taxes of an early withdrawal aren’t worth it.
Wait, I Don’t Have Enough To Max Out My 401k And Also Save For Early Retirement
Then I haven’t explained my story well. I started with $800 making $25,000 a year. I didn’t make $60k a year until I was 30. We have not been married long (so I haven’t had two incomes). I didn’t have an endless number of YouTubes and blogs that I could research (which seem to mostly be people saying what they will do, and not what they have done).
I didn’t have help from my parents or anyone else. It was $800 I had saved working at a gas station making $5 an hour.
As a teenager I read Carleton Sheets books on No Down Payment and The Millionaire Next Door: The Surprising Secrets of America’s Wealthy. I would also go to the library and read newspaper listings and whatever I could get my hands on.
For me phase 1 was leverage buying real estate that other people paid off, and phase 2 was maxing out my 401k. All along I have made decisions around spending just enough money to make me happy, no less and no more (aka satisfice).
Bottom Line On Whether You Should Max Out Your 401k
Should you max out your 401k. Yes. It’s hard. But you can do it. Older you will be proud of you because you are making their life so much easier.
I also want to be sensitive. There are many people who can not afford to max out their 401k. The odds are low that they stumbled across this article, or read this far in it. A front line worker at Taco Bell is not likely to be reading this.