When You Should or Should Not Max Out Your 401k - Ep #74
Welcome to episode 74 of the One for the Money podcast. I am so very grateful you have taken the time to listen. In this episode, I will share when you should max out your retirement plan such as a 401k and when you should not.
In the tips, tricks, and strategies portion, I will share a retirement saving tip for those who don’t have access to a retirement plan through their job.
In This Episode
1978 Revenue Act [1:05]
When Not to Max Out Contributions [3:03]
When You Should Max Out Contributions [6:46]
1978 was a watershed moment in the history of retirement for Americans. That was the year that a Revenue Act was enacted by Congress and established 401k and 457b retirement plans. 401k retirement plans are for the private sector and 457b plans are for state and local government employees, as well as employees of certain tax-exempt organizations. These plans now allowed employees to defer some of their income and avoid taxes on that income until they take it out later in retirement. This was huge. People could now save for retirement in tax-advantaged ways.
Prior to that, most Americans relied on pensions from their employers for income in retirement. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement. And that was feasible when people worked for several decades for the same employer and didn’t live that long in retirement. But as individuals started changing jobs more frequently for better opportunities and people's life expectancy increased significantly, the pension system became untenable for both the public and private sectors. 401ks are for companies government employees use 457b plans and public school employees (teachers) and non-profits use 403(b) plans.
Specifically regarding 401ks, 68% of private-sector American workers currently have access to an employer-sponsored retirement plan.
For those Americans who have access to a retirement plan at work be it a 401k, 403b, 457b, SEP IRA or Simple IRA some wonder whether it makes sense to max it out every year. As with any financial planning, it depends upon your unique situation and circumstances.
When you should NOT max out your 401k/403b/457b/SEP or Simple IRA
There are times when you shouldn’t max out your retirement account. One of the most obvious reasons is if you have high-interest debt that needs to be paid off first. However, I would recommend in this scenario that you at least contribute to the company match as that is free money. No higher contributions should be made until after your high-interest debt is paid off. You need to pay down high-interest debt, such as credit card debt. The average credit card currently has an APR of more than 20%, which is well above the amount you could reasonably expect to earn on a diversified portfolio in any given year. That’s why it is always better to funnel extra cash toward paying down high-interest debt instead of maxing out retirement plan contributions.
Another reason not to max out contributions to your work retirement plan is if you don’t have a sufficient emergency fund. As a reminder, you should have 3-6 months of your minimum expenses in savings to cover a potential financial emergency. We learned this firsthand a few months ago when our eldest son nearly drowned while surfing. He was rushed to the hospital and was released the next day, but I was glad we had the savings to cover the incredibly high costs we incurred as a result.
A third reason why you shouldn’t max out your company retirement plan is if you haven’t yet funded a Health Savings Account or HSA. As a reminder, HSAs are available to individuals with qualifying high-deductible medical plans. HSAs are incredibly powerful as they are the only triple tax-free retirement account and they have the added advantage of early accessibility. You should max out your HSA before maxing out a retirement account. Another huge advantage of HSAs is that they can be accessed at any time without penalty for qualified medical expenses, whereas 401ks it can be as early as 55 and IRAs its as early as 59.5. See episodes 2 and 49 for more on HSAs.
A fourth reason why you may not want to max out your contributions to a retirement plan is if the plan has high costs and/or poor-quality investment options. Across the retirement industry, the majority of plan participants pay less than 80 basis points in combined costs (including administrative fees for the plan plus expense ratios for the underlying investment options). But costs span a wide range. If you work for a smaller employer, you’re more likely to be saddled with a higher-cost plan. In episode 73, I shared an example of a client that had hugely expensive investments. One had a management cost of nearly 2% and it had inferior performance.
A final reason not to max out your workplace retirement plan is if you plan to retire before 55 you cannot access your money without a hefty penalty. If you roll your money to an IRA then you won’t be able to access your money without a hefty penalty until 59.5. Keeping your money in a 401k has that advantage over an IRA. When you invest in a 401(k)/403b/457b plan, your contributions are effectively off-limits until age 59½ (or 55 for retirement plan participants who have separated from service).
Here are reasons when you SHOULD max out your 401k/403b/457b/SEP or Simple IRA
If someone is behind on saving for retirement, it’s imperative to stuff as much money as you can into a 401(k)/403b/457b as these allow you to put away the most amount of money in tax beneficial vehicles. In 2024 people can contribute $23,000 and if you are 50 or older you can take advantage of catchup contributions and contribute an additional $7500 or $30,500 in total.
I recommend when you are young that you put in as much as you can in retirement vehicles because the longer your money is invested the greater the potential growth. I didn’t start saving in my 401k until I was nearly 30 and I didn’t make great money, but through budgeting, maximizing my 401k and selecting the right investments, and following a sound financial plan we are on track to have a great retirement.
Another compelling reason to max out contributions to your pre-tax 401(k)/403b/457b is if you expect to be in a lower tax bracket after retirement. Most retirement savers have less taxable income after they stop working. Of course, tax rates can change in the future, but given the American government’s reliance on income taxes and the fact that lower incomes pay at lower tax rates you can benefit from contributing as much as you can to the pre-tax 401(k)/403b/457b account. Contributing to a pre-tax retirement 401(k)/403b/457b account can also be used by early retirees to greatly lower their taxes in retirement by employing Roth conversions during their first few years of early retirement. There are a lot of factors to consider, but I have employed these for my clients and it will save them hundreds of thousands of dollars in taxes. See episode 49 of this podcast for more details.
Another reason to max out your retirement plan contributions is if you think your tax rate will be higher in retirement. Of course this time the recommendation is to contribute to a Roth retirement plan account as it will allow you to put away way more money in a never-taxed-again retirement account, allowing it to compound and grow tax free for as long as possible.
I hope I was able to provide a better understanding of when and when not to max out your work retirement plan such as a 401k, 403b, or 457b. There are many factors to consider when making these decisions and having a certified financial planner provide guidance can be a tremendous help. Feel free to schedule a no-cost or obligation meeting with me on my website at betterplanningbetterlife.com
Thank you again for listening and I hope you found this helpful, now on to the tips tricks and strategies portion of the podcast.
TIPS, TRICKS AND STRATEGIES
Welcome to the tips, tricks and strategies portion of the podcast where I will share a saving tip for those that don’t have access to a work retirement plan such as a 401k, 403b or 457b.
There are a few reasons why you may not have a work retirement plan. If you are a small business owner, these can be expensive. In episode 35 of this podcast, I highlight the different options available to you. The options mentioned in that episode include IRAs, Sep IRAs, Simple IRAs, Solo 401ks, and defined benefit plans.
A great option if you don’t have access to a retirement plan is to save in a non-retirement account. These accounts have a few advantages over retirement accounts. The first is that they can be accessed at any time (no having to wait until age 55 or 59.5). The second advantage is that for investments held for longer than a year, the taxation will be at the generally lower long-term capital gains rates than the generally higher income tax rates. Now you will be required to pay taxes annually on any dividends and interest received but this annual taxation has less of an impact than most people think.
I will share an example where $10,000 contribution is made each year into a Roth 401(k) versus a $10,000 invested each year into a taxable account (i.e. brokerage) for over 30 years. This analysis is courtesy of Nick Maggiulli of Dollars and Data.
For this comparison, it assumed that both accounts grew at 5% a year and that the taxable account had to pay the long-term capital gains rate of 15% on a 2% annual dividend and when the portfolio was sold (in the last year). This means that no sales were made in the taxable account until retirement (when all long-term capital gains taxes are paid). It’s buy and hold for three decades. After running this simulation for 30 years, it was found that the Roth 401(k) ended up with $114,000 more than the taxable account (after all capital gains taxes had been paid):
That $114,000 means that the Roth 401(k) ends up with 14% more than the taxable account after 30 years. That may seem like a lot but if you break it down by how much of a benefit it was per year it was only 0.73%. That’s it. You get a smaller return, just 0.73% in extra return each year to lock up your capital until you are 59½.
There are many factors to consider regarding when choosing the type of retirement or non-retirement account best aligned with your goals. I recommend that you speak with a Certified Financial planner who will listen to your goals, analyze your tax return, and designs an investment and financial plan to help you achieve your goals. Listen to the end of this episode for how you can schedule a no-cost or obligation with me. Again, I hope you found this helpful Remember a better life is a result of better planning. Have a great one!
RESOURCES
401(k): What It Is, How It Works, Pros, and Cons
Should You Max Out Your 401(k)?
Should I Max Out My 401k? [The Surprising Truth]
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