Should You Max Out Your 401(k) Contribution?

Last year, the IRS increased 401(k) contributions for 2019 to $19,000 annually (versus the maximum contribution limit of $18,500 for 2018). That means that workers looking to max out their 401(k) should be reviewing their contribution percentages now to account for that extra $500.

However, before you go forth and do, you may want to pause a moment and ask the question, “Does it make sense for me to max out?” While I am all for making retirement savings a priority, that doesn’t necessarily mean contributing the max to your 401(k) is right for your situation. Before you make any adjustments to your contribution percentage, consider the following:

Does your employer match?

If the answer to the above is yes, then you’re in luck. Taking advantage of employer 401(k) contributions is the fastest way to build a nest egg for retirement, as you are essentially doubling your own contribution for free! The amount you need to save to get the maximum possible 401(k) match varies by employer, but frequently requires saving approximately 6 percent of pay. Any time there's an employer match, it makes sense to at least contribute enough to receive the full match.

Do you have high interest debt?

If the interest rate you are paying on your debt is higher than the return you expect to earn on your investment, it makes sense to pay down the debt first. In this case, paying off a high interest debt, like a credit card balance, should take priority over additional 401(k) contributions above the amount needed to receive any match.

Those who have low interest debt, such as you might pay on a mortgage or student loans, may come out ahead by prioritizing saving for retirement. However, some people prefer to eliminate a specific debt before maxing out a retirement account. In this case it's about creating a plan that a person will stick to because it makes them feel better. Then when the burden of debt is relieved, they feel in a stronger financial position to increase retirement savings.

Do you have an emergency fund?

You need a cash reserve outside of your retirement account to cope with unexpected expenses. You don't want to have to raid your 401(k) plan, and incur the taxes and fees associated with an early withdrawal, to cope with an emergency expense, such as a car or home repair or medical bill. Ideally, you want three to six months’ worth of monthly expenses set aside in emergency savings and $0 in bad debts before considering maxing out your 401(k). Many people who skip the savings and debt part of the equation eventually end up backtracking by stopping contributions to their 401(k), taking out loans against their 401(k), or worse, taking early withdrawals from their 401(k) when emergencies do arise. 401(k) withdrawals before age 59 1/2 typically trigger a 10 percent early withdrawal penalty, and income tax is also due on the distribution. So, a 35-year-old worker in the 24 percent tax bracket who withdraws $1,000 from his 401(k) plan could trigger $340 in taxes and penalties.

Does your 401(k) have high fees and expenses?

Some 401(k) plans provide excellent investment options and negotiate for low fees on behalf of employees, while other 401(k) accounts are riddled with poor investment choices and excessive fees. If your 401(k) plan doesn't have the investments you want or has high fees that are eroding returns, after you get any 401(k) matching funds, you may want to further save for retirement somewhere else. Think about the quality of the offerings within the 401(k) investment lineup. Could you potentially get lower cost passively managed funds, such as ETFs, with an IRA, rather than investing in the 401(k) plan? If so, contribute enough to your 401(k) for the company match and consider putting the rest of your retirement savings in the IRA.

What are your other savings goals?

Many people have more immediate financial goals than saving for retirement. As such, sometimes it makes sense to try to balance short and long-term goals. For example, if you're planning to buy a home in the next couple of years, but you're using your cash flow to max your 401(k) contributions, you'll obviously have less money to save for a down payment. Remember that savings does not have to be “all or nothing.” Instead, you can work towards both retirement and a house down payment by contributing just enough to the 401(k) plan to qualify for employer contributions, and then prioritize your more immediate savings goals.

What’s the taxable impact of contributing to my 401(k) plan?

You can defer paying taxes on as much as $19,000 in a 401(k) plan in 2019, or $25,000 if you are age 50 or older. A 40-year-old worker in the 24 percent tax bracket could reduce his tax bill by $4,560 if he maxes out his 401(k) plan in 2019. The tax savings is even greater for workers who pay a higher tax rate. Remember to factor in tax breaks when deciding whether to fund a retirement account or prioritize other more immediate expenses.