Today, the 401(k) is a standard way that Americans save for retirement. Because these plans provide tax benefits and a potential employer match, many investors aim to max out their contributions, or contribute up to the Internal Revenue Service (IRS) annual limit.
For 2022, the contribution limit is $20,500 per year for workers under age 50, and $27,000 for those 50 and older. However, many employees cannot contribute up to the limit, depending on their personal financial situation. Others may find that maxing out a 401(k) is not ideal if the plan’s asset options don’t align with their goals.
In this article, we’ll look at how maxing out your 401(k) works and what you can do if you cannot contribute up to the limit.
- A 401(k) offers tax advantages and potential employer matches, so many investors aim to max out their contributions.
- Contributions to a 401(k) are made with pretax funds, so they reduce your taxable income.
- You may not want to max out your 401(k) if your employer plan offers limited investing choices and with high fees.
- Financial advisors often recommend contributing at least up to an employer match.
- In general, consider contributing as much as you can to a 401(k), even if you can’t contribute the maximum.
Should You Max Out Your 401(k)?
When you max out a 401(k), you maximize your tax benefits and create more financial security for your retirement. Your contributions to a traditional 401(k) plan are tax deferred, so you won’t pay any tax on them until you withdraw them in retirement (when you’ll likely be in a lower tax bracket, anyway). With a Roth 401(k), you contribute after-tax money but can make tax-free withdrawals in retirement.
Some employers will also make matching contributions up to a certain percentage of your salary. For example, if you put $5,000 in your 401(k), your employer may also contribute $5,000.
Potential Downsides of Maxing Out a 401(k)
But maxing out a 401(k) is not necessarily ideal for all investors. In fact, only about 3.6% of workers max out their 401(k), according to the IRS.
Some investors may not have the cash flow to deduct the maximum contribution from their paycheck. They may need to use their earnings for necessary expenses before saving the maximum for retirement.
In addition, depending on the company you work for, investing heavily in a 401(k) plan might not be the best choice for you. That’s because 401(k) plans provide different investment choices. Since your employer administers the plan, they decide what assets to offer. In some cases, your 401(k) investment options may be very limited.
Finally, some 401(k) plans may not be attractive because of high fees. A 401(k) plan requires management and administration, and 95% of 401(k) plan participants pay fees. Plans with lots of participants sometimes benefit from economies of scale, so they may have lower fees than those offered by smaller companies. According to a 2021 report, the average fee for a 401(k) account ranges from about 0.88% to 1.19%, but your expense ratio could be much higher.
How Much Should I Contribute to My 401(k)?
If you decide to invest in your 401(k), you’ll also have to decide how much you want to contribute from your paycheck. For most, the tax advantages and employer match make a 401(k) the best place to invest for retirement.
A common rule of thumb is to aim to save 15% of your income for retirement. If 15% of your income is more than the 401(k) contribution limit, then you will need to invest your funds in another account to maintain that percentage of savings toward retirement.
If you can’t afford to max out a 401(k), aim to contribute what you can. Investing just a few hundred dollars a year can help provide a source of funding for retirement. If your employer offers matching contributions, aim to contribute at least up to the limit of these so that you are not leaving “free money” on the table.
Before contributing to your 401(k), consider paying down high interest debt, building up some emergency savings to cover unexpected events, and ensuring that you are on track for your short-term financial goals (such as getting married or buying a house). After that, you’ll likely want to put as much as you can afford into your 401(k).
Should I max out my 401(k)?
In most cases, you should try to max out your 401(k). For most people, the tax advantages of a 401(k), plus a potential employer match, will provide strong benefits for saving for retirement. However, if you have a tight budget, or if your plan has high fees or limited investment choices, you might want to consider investing in another type of account, such as an individual retirement account (IRA).
What are the maximum contribution limits for a 401(k)?
For 2022, the annual limit on employee contributions is $20,500 per year for workers under age 50. However, those 50 and older can make a $6,500 catch-up contribution.
What if I can’t max out my 401(k)?
If you can’t max out your 401(k), create a budget that aims to set aside as much as you can for your retirement. Factor in high-interest debt and other financial obligations as you develop a plan for annual savings.
The Bottom Line
For most workers, a company-sponsored 401(k) is a good option to save for retirement. However, only about 3.6% of workers max out their 401(k).
There are also some circumstances in which it makes sense to invest your money elsewhere, such as if your employer offers a limited plan with high fees. In general, though, 401(k) plans offer substantial benefits, so maximizing contributions can boost your savings.