Can there be too much of a good thing? Absolutely. If you doubt it, buy a few gallons of your favorite flavor of ice cream — and then eat all of it.
Saving for retirement in a 401(k) plan is a very good thing. Too few Americans do enough of it. But does that mean contributing the maximum possible amount each year to your 401(k) is smart? Not necessarily. Here’s the unfortunate truth about maxing out your 401(k).
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Robbing Peter to pay Paul
Perhaps the biggest near-term risk associated with maxing out your 401(k) is that you might not have enough money left over to address other important financial goals. Saving for retirement is commendable, but it can create problems when it prevents you from saving for other priorities.
In particular, every household needs to establish an emergency fund. Ideally, you should have at least three to six months’ worth of expenses saved to make sure you can pay your bills if something happens that makes you unable to earn income (for example, becoming seriously ill or losing your job). If you don’t already have an emergency fund, maxing out your 401(k) isn’t a great idea.
Even if you have built an adequate emergency fund, contributing the maximum to your 401(k) might not be your best move. If you plan to buy a house soon, maxing out your 401(k) could limit how much you can put on a down payment and force you to take on more debt.
It’s important to remember that retirement will likely be only one of several savings goals. Make sure you consider all your financial priorities and allocate your extra money after covering your expenses wisely.
Affecting your retirement
You might be thinking, “I have an emergency fund. I’m addressing my other financial priorities. Maxing out my 401(k) is a no-brainer, right?” Again, not necessarily.
Believe it or not, contributing the maximum to your 401(k) plan could negatively affect your retirement. This might seem counterintuitive. It’s not, though, because of one simple reason: 401(k) plans aren’t the only way to save for retirement.
Employers control the options you have in your 401(k) plan. These options will usually be more limited than those in an individual retirement account (IRA) or a health savings account (HSA). As a result, maxing out your 401(k) could be forfeiting an opportunity to make greater returns you could have generated by putting some of your retirement savings in an IRA or HSA.
Some 401(k) plans also have higher fees than IRAs or HSAs. These fees can slowly and steadily eat into your returns. Over several decades, this can add up to a great sum of money that you won’t have in retirement.
Maxing out your 401(k) might be especially problematic if your employer only offers a pre-tax 401(k) and not an after-tax Roth 401(k). Pre-tax 401(k) plans are great if your tax rate will be lower in retirement than during your working years. However, with the national debt continuing to soar, tax rates may have to rise significantly at some point down the road. If so, shifting some of your retirement savings to a Roth IRA could end up working to your advantage.
One good approach
So what should you do to save for retirement? Each person’s financial status and goals will differ. Talk to a reputable financial advisor about the best strategy to meet your needs. That said, here’s one good approach that could be appropriate for many people.
First, contribute at least enough to your 401(k) to maximize your employer match. These matches are basically free money that everyone should claim.
After contributing enough to your 401(k) to get the full employer match, look at your other savings priorities. Whether it’s buying a house or saving for your children’s education, make sure you’re socking away enough money to achieve your goals.
If you still have money left over, consider investing in an IRA and/or HSA. Finally, if you max those accounts out and still have extra money (congratulations, by the way!), contributing more to your 401(k) could be your best move. And then go eat some of your favorite ice cream — but not too much.
