I was reading Joe’s Udo’s Retire by 40 article asking, “What if you always maxed out your 401k? The first question that popped into my mind was, “Should you even max out your 401k? I used to think you should definitely max out your 401k if at all possible. Now, I feel the opposite. I don’t find myself changing my mind on too many things. So how did I get here?
Can You Max Out Your 401k
When I started as a software engineer in 1998, I was making around $34,000. I lived with two roommates and drove an Oldsmobile Delta 88 that my mother passed down when she got a new car. I could live fairly frugally.
With those circumstances, I was able to max out my 401k. Back then the maximum was around $10,000. I was even able to contribute $2,000 to my Roth IRA. That was a lot of saving back then. It also helped us have the potential of a great retirement income. At least a lot of it was pre-tax money, so it didn’t feel like my paycheck was that much smaller.
Times have changed. It’s nearly 25 years later. The 401k maximum contribution now is over $20,000. The cost of living is a lot higher. I didn’t have student loans, because I had gotten a scholarship. That seems very rare today. Rents are much higher now than they were then. Good luck if you want to put away money for a house – getting a 20% down payment seems out of reach nowadays. Used cars and food are much more expensive due to the inflation we’ve seen.
It’s not a pretty picture when you look at how much you’d have to max out your 401k after all that. Also, consider that in almost all cases, it would be wiser to max out your Roth IRA of $6,000 first.
The good news is that you’d probably make more money. The bad news is that it might not be too much more. As a software engineer, I would have probably done well in either era, but if the median salary in 1998 was ~$38,000. Today it isn’t that much more, ~$44,000.
Maybe as you get older and move up the corporate ladder it would seem easier to max out your 401k. In some time, you’ll probably have a spouse, which is great for splitting expenses and growing income. However, there’s bad news. You may want to buy that house and you may have kids coming. It might not get easier to max out your 401k.
If you get through all that, you are ready to ask the real question:
Should You Max Out Your 401k?
For the longest time, I believed that if you could afford it, the best plan was to max out all your retirement options.
Now, I think very differently.
We maxed out those retirement accounts whenever we could. The only problem is that now, at age 45, it isn’t easy to get that money back out to retire early. Some bloggers have detailed a lot of ways and they work for a lot of people. The main premise is that you’ll be using the money in the retirement to fund your entire retirement. In that scenario, you can get a lot of money at very, very low tax rates. It makes a lot of sense.
However, we aren’t normal because my wife has a pension. I also have a couple of side businesses that I’d do no matter what. So when we try to get money out of those retirement accounts, we’re starting at a higher tax bracket. I’m not sure it is any better than the tax bracket where I saved the money. I’m sure that many of you don’t have pensions, but I know a lot of people who continue to earn an income in retirement.
Furthermore, when I was putting money in my 401k, the investment options were… not great. Some of the funds had fees over 1%. Fortunately, I knew how to look for expense ratios and did the best I could with the options available to me. I’ve heard those fees are better now. I hope so.
In hindsight, I may have been better off just putting the after-tax money in a brokerage. Maybe I could have bought dividend stocks and held them for a long time. Then I’d awesome qualified dividends that would be taxed at around 15%. That’s a good tax rate compared to the bracket we may be in during retirement.
The biggest benefit to maxing your 401k, in my opinion, is that it is forced savings. You don’t need to save the money afterward and risk spending it on mountains of Swedish Fish. You never had the money in the first place.
I’m going to suggest that maybe you should be careful about maxing out your 401k. Obviously, at some very high-income levels, it may be fine. At these levels, a Roth IRA isn’t an option. At the income level of the vast majority of people, I’m not sure it makes sense to max out your 401k. I think it’s better to max out your Roth IRA and then maybe do half the max of a Roth IRA and half of after-tax directly in a brokerage for investing in safe index funds.
What do you think? Does maxing out a 401k make sense for more than a few outliers nowadays?
You really should max out your [ROTH] 401K
Yes, I didn’t think about Roth 401ks, because they didn’t exist when we had that option. My wife has a similar option with a Roth TSP that we maxed out for a while. However, we’re at the point now where we have more money in retirement accounts than accounts we can live off now, so we’re stopping.
So I will say it depends. What are your retirement goals? If you plan on retiring at 50 putting all your money in your 401k (which will tax you and penalize you if you hit it anytime in the next 10 years) is not smart. I know you have people like Sam at Financial Samurai who say heck yes, and he has lots of pretty graphs to show this.
My answer is totally based on you planning on retiring early, and you are under the Roth max cap for income (which I am not for the first time in my life – single life and good paying job – so no Roth in 2021).
First thing – no matter what – get your whole company 401k. That is just crazy to leave free money on the table. If this is all you can afford, well, then at least you didn’t leave free money.
If you have money left over, put it in a Roth to the max.
If you have money left over, and if you have a Roth 401k, take advantage of that as the contribution limits follow 401k, and you can roll over to a Roth if you leave the company.
If you have maxed out your 401k, Roth, Roth 401k (in that order), and you still have money left over, put it in a taxable account. There is no limit how much you can invest in a taxable account.
My reasoning for this is many fold, but basically you have to look how you are going to live when you are retired and before you can get into the 401k. You can take from your taxable accounts at any time. You can then take from the CONTRIBUTIONS from your Roth (not earnings) before 59 1/2. Then you can start taking from your Roth and 401k (or Rollover IRA if you have rolled over old 401k) when you hit 59 1/2. Basically you are creating a tiered system of contributions, to maximize tax benefits (present and future).
I have spreadsheets on this, and this is what I found to be the best. However due to income this year finally pushing me over the max for Roth, I can just contribute to the Roth 401k and regular 401k and taxable (for the first time since 1999).
I think this is probably the best plan for most people. I might still put more money in a regular taxable account before a 401k if I could do it all over again. Roth 401k didn’t exist, so they weren’t an option.
I have a hard time convincing myself to take out Roth IRA Contributions. It’s losing a lot of compounding that you don’t have to pay taxes on and you can’t get it back. That’s why I like the taxable account. If you can make qualified dividends with that the tax hit is fairly minimal.
Up until 2021, I did about 1/3 taxable, 1/3 Roth, 1/3 401k. 2021 that changed as I no longer could contribute to Roth (nor going forward in the foreseeable future). The reason I like the Roth is you have the “possibility” to remove contributions, This is really a backup in case your taxable goes kaput and you need more money before 59 1/2.
I consider those Roth IRA contributions as a hidden emergency fund. It’s nice to know that there’s some money that sufficiently hard to get to that would be tempted, but also easy enough that if it was needed to avoid being homeless, it’s there.
The best thing about 401k is the forced saving, as you pointed out. Having money locked away when you’re young is a good thing. Most people can’t save when the money is readily available.
Also, 401k accounts have a lot better investment choices these days. At least the ones I’m familiar with are way better than in the 90s. You can get good index funds without paying a ton of fees.
You can also build a Roth IRA ladder to access the funds. It isn’t 100% locked away.
However, it’s probably not the right move if you have big pension coming. You probably won’t save much with the tax bracket.
Once my wife retires and our son goes off to college, I want to travel a lot more. At that point, we won’t have much earned income. It should be a good time to withdraw.