The Problems You May Cause If You Max Out Your 401(k)

Rawpixel.com/Shutterstock

If you have a 401(k) through your employer, you have a good way to prepare for retirement. It is even better if your employer is giving you matching contributions. This fact alone can make investing in a 401(k) a worthwhile investment. Still, there are some things you need to think about before maxing out your 401k contributions every year.

The Positive Aspects of Having a 401(k)

• Its Convenience

Once you sign up for paycheck withdrawals and put them into your 401(k) account, you can forget about it. Every payday more will be contributed to your retirement account, and it grows even faster. It is not going to be much simpler than that.

• Its Potential

Another 401(k) benefit is that you can contribute much more than you could to an individual retirement account (IRA). An IRA lets you contribute only $6,000 annually if you are under 50, but $7,000 if you are 50 or older. This limit has been unchanged since 2019.

A 401(k), on the other hand, enables you to contribute up to $20,500 in 2022 to a single employer’s plan. You can put an equal amount into a separate 401(k) through non-elective contributions. The Internal Revenue Service (IRS) says that owners of these accounts benefit from the cost-of-living adjustments, two of which have occurred since 2019.

Employers can also make matching contributions to a 401(k). When they do, it enables your retirement funds to grow much faster.

Many wealthy people use 401(k)s because of the tax advantage. Although you do pay taxes on the front end, there are no taxes on your withdrawals—even on the interest.

The Negative Aspects of Maxing Your 401(k) Contributions

If you are focused on building up a large amount of money for your retirement, there are some things you may want to consider before maxing out your contributions. They include:

• Not Having Sufficient Funds Now

Although you may want to ensure that you have a good amount of cash for fun and comfort during retirement, ask yourself if you have enough for some fun now. It is not a good idea to live on a bare-bones budget now if it is not necessary.

If the budget is tight—because you are striving to max out your 401(k)—decrease your contributions, spend some money and create a few fond memories with your family. They will appreciate the time spent together more than helping you save for retirement.

• Pay Your Bills First

Struggling to pay your bills is another sign you should not be maxing out your 401(k). Most likely, the interest you are paying on loans or credit card debt is higher than you are getting in your retirement account. This means you are losing money each year on interest.

Reduce your contributions enough to get caught up on your bills and eliminate your debt as soon as possible.That’s not to say you should not make contributions; but paying off your debt will enable you to have more money each month to enjoy life more.

• Not Having Access to Your Money Without Penalties

If ever you have an unexpected need for cash before you turn 59½, it will cost you to get it out of any retirement account—and 401(k)s are no different. Schwab says that withdrawals made before you turn 59½ will require you to pay taxes on the money, and you will also pay an additional 10 percent penalty fee.

You can prevent a cash problem if you do not max out your 401(k) contributions each year and keep some money liquid. Various savings plans (not retirement) can give you access to some of your money quickly that do not have penalty fees on withdrawals.

• Limited Investment Options

Your employer’s 401(k) could be limited in the available choices for investment. If so, it could reduce your ability to make as much interest as possible. Fool.com says that some 401(k) retirement plans have expense ratios of 1 percent or more, along with an additional similar percentage for administrative fees. You could do much better than this and keep more of your interest with basic index mutual funds—which might cost 0.05 percent or less.

An employer’s 401(k) may not, however, offer excellent investment choices. Fool.com also mentions that you may not be able to buy individual stocks, bonds, exchange-traded funds (ETFs), or options. The selections offered may not give you the range of options you would prefer.

• The Type of 401(k) Matters

A traditional 401(k) allows you to put money into the account tax-free. You get a deduction for money deposited and pay the taxes when you withdraw the money.

A Roth 401(k) is the opposite. You pay taxes on your contributions and have the advantage of seeing your money grow. In retirement, you will not pay any taxes on the money—not even on the interest.

The goal of the traditional 401(k) is to save you money on taxes. TurboTax says that if you are in a lower tax bracket during your retirement years, you will pay fewer taxes. If you think you will be in a higher tax bracket in retirement, you'll want to use a Roth 401(k) to reduce your taxes by paying them upfront.

Other Investment Options

Besides 401(k)s, there are other investment options. A health savings account (HSA), for example, works similarly to a Roth 401(k), except that it is primarily for health needs. It is an excellent way to save money for retirement. When you need money for medical purposes, you can withdraw the money without any tax penalty. Otherwise, you will pay standard tax rates on withdrawals.

An HSA has smaller contribution limits than an IRA—$3,650 for an individual or $7,300 for a family. People 55 or older can make catch-up contributions of $1,000. Once you reach 65, you can use the money for any purpose.

Annuities or investment accounts, Investopedia says, are other good places to invest your money. Investment accounts may even offer higher interest rates than a 401(k), but they may also have a higher risk. You can also invest in a business, or buy real estate for an investment opportunity.

Besides maxing out your 401(k), there are other ways to keep some money liquid or make even more interest. Take time to plan the best way to use your money—for now, and in the future.

The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.