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?