Why You Should (and Should Not) Max Out Your 401(k)

It Does Not Always Make Sense to Contribute the Max to your 401(k)

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Eat healthy. Stay active and exercise. Get a good night’s sleep. Save for retirement. These are all important best practice suggestions that contribute to our overall health and well-being. But sometimes knowing you should be doing something to improve your current and future self isn’t enough. You need some guidelines and an action plan to help you out along the way.

When it comes to saving for retirement a general guideline is to save, save, and save some more. Making contributions to a 401(k) or similar retirement plan may seem like a no-brainer with numerous reports highlighting the fact most Americans don’t feel like they are on track to meet their income goals later in life. In fact, most personal finance experts suggest saving somewhere between 10 to 20 percent of your income throughout your working career. All of this is geared towards getting you to the 80 percent income replacement benchmark.

Of course, these are just benchmarks and your personal financial plan should be—well, personal.

When You Should Max Out Contributions to Your 401(k) Plan

A best practice suggestion is to at least save enough to capture your company match if provided. There are many situations where going above and beyond the company match is needed to fund retirement goals. In 2018 the maximum amount you can contribute to a 401(k) plan is $18,500 ($24,500 for ages 50 or older).

Here are some financial milestones that need to be in place before contributing as much as possible to your 401(k):

  • You have at least 3 to 6 months of basic living expenses set aside in an emergency fund.
  • You have eliminated high interest credit card debt, personal loans, car loans, etc.
  • You are on track to reach shorter-term financial life goals such as having a child, buying a home, or another major purchase.
  • You have adequate life insurance coverage.
  • You have a formal estate plan including wills and other critical documents (living wills, health care power of attorney, trusts, etc.).
  • You are contributing up to the maximum amount possible to your Health Savings Account (if covered by a high deductible health plan)
  • You have adequate disability insurance coverage to protect you and your family if you miss work for six months or more.
  • If you are nearing retirement you have long-term care plans in place (LTC insurance, self-pay, etc.).

When You Shouldn't Max Out Contributions to Your 401(k) Plan

While contributing up to the maximum amount possible to a 401(k) may sound ideal, it isn’t the right approach for everyone. For one thing, not everyone is in a position to contribute $18,500 per year to a retirement plan. If you earn $50,000 per year this is 37 percent of your total income. It’s okay to acknowledge you may not have the excess cash flow needed to make this happen.

The entire retirement planning process is a balancing act of setting aside money aside for later while attempting to meet the needs and desires for today. If you have accumulated significant credit card debt or have high interest non-mortgage debt (e.g., greater than 6 percent) you should typically maintain debt-reduction as a higher priority goal. Similarly, if you do not have a fully funded emergency savings account in place you may want to focus on that before ramping up retirement savings above your employer match.

There are other reasons to reconsider maxing out 401(k) contributions. If your retirement plan at work is burdened by high fees and expenses or has a lackluster investment lineup you may want to hold off on going above and beyond the company match. Other tax-advantaged retirement accounts such as traditional or Roth IRAs will allow you to contribute up to $5,500 per year ($6,500 for those age 50 or older) and give you more control over your investment options.

As you can see sometimes it makes sense to max out your 401(k) and sometimes you may need to limit your contributions. The first step when determining how much you should contribute is to assess your overall financial situation. If you have a solid financial foundation in place and your employer sponsored retirement plan is loaded with excellent features, maxing out your contributions makes sense. If you are still working on other aspects of your financial life plan that’s a sign that you should likely hold off on increasing your 401(k) contributions.

The good news is that paying off high-interest debt, building up your emergency safety net, and focusing on other financial goals are also important steps on the path to true financial wellness and provide a sense of greater retirement preparedness.