You’ve probably heard it a million times: max out your 401(k). That advice ranks right up there with “eat healthy” and “get regular exercise.” No doubt, this retirement savings strategy, which relies on funding your 401(k) up to the contribution limit, can boost the size of your nest egg. But putting every spare penny of savings into a traditional 401(k) is akin to putting on a financial straitjacket.
Just like the downsides of being house rich and cash poor, it’s possible to have a sizable nest egg and still run into liquidity issues or other money-related obstacles that can put stress on your finances.
While there’s no denying that taking advantage of the upfront tax break, tax-deferred growth, a potential employer match and automatic investments that a traditional 401(k) offers, there are also risks to putting all your investable assets in one basket: a 401(k) funded with pre-tax dollars.
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Should you max out your 401(k)?
Get the match. No matter what, it’s a given that investors should put enough in a 401(k) to at least earn matching contributions, says Christine Benz, director of personal finance and retirement planning at Morningstar. There’s no reason in the world to leave money on the table.
Know your company plan. So, the first question you’ll need to answer is what the 401(k) match is at your company. Is it generous? (The average match is 4.6% of pay, according to Vanguard.) Do you earn that match from day one, or do you have to work for a few years first? Are you vested right away? If you plan to leave your company before you are eligible for a match, then you may not want to invest in the company’s 401(k) plan.
Once you are familiar with your company’s 401(k) plan, here’s how to determine if you should contribute the maximum allowable amount.
The hidden downsides of maxing out your 401(k)
It’s often said that in life, stuff happens. And when financial emergencies strike, or you’re intent on buying a new car or a vacation home, being able to access your money easily and penalty-free is crucial. That’s why having the bulk of your money tied up in a traditional 401(k) can handcuff you.
Before tying up your hard-earned cash, you should understand the drawbacks of traditional 401(k)s (and related accounts such as traditional 403(b)s and 457(b)s). Since distributions are taxed as ordinary income, large 401(k) withdrawals in your retirement years when spending spikes can push you into a higher tax bracket and boost your tax bill.
IRS rules also place restrictions on accessing your money before age 59 ½. If you do, you will most likely be hit with a 10% early withdrawal penalty on top of any taxes you incur. Your traditional 401(k) may also lack a strong lineup of funds to choose from, offer a meager company match, or charge hefty fees that bite into your returns.
Financial experts say you should still save as much as you possibly can. The key is to spread your money across different types of accounts to ensure you have the most financial wiggle room for cash flow and taxes, no matter your age.
“One of the biggest downsides is the lack of financial flexibility before you hit your full retirement age,” said retirement expert Roger Young, a thought leadership director at T. Rowe Price.
Many Americans retire early, get laid off late in life or have a large pending purchase or bill. As a result, they may face financial challenges that traditional 401(k)s are not designed to address. The problem is the inability to withdraw money as needed in a tax-efficient, penalty-free way.
“So, it is definitely helpful to have money in different places so that you have access to it without penalty,” said Young.
Tax diversification is the winning strategy
Spreading your savings across investment buckets with different tax treatments provides maximum flexibility.
“Having tax diversification is really critical,” said Chris Kampitsis, a financial planner at Barnum Financial Group. “Having some money in a Roth bucket, a brokerage account, and an emergency fund in cash or cash equivalents allows you to call your shots in terms of the tax rate that you’re going to be looking to be in throughout retirement.”
Indeed, being able to choose between a tax-free Roth withdrawal, a lower capital gains hit from a brokerage account, or cash or a traditional 401(k) withdrawal provides ample options, depending on financial circumstances.
There are plenty of options to better manage your tax hit.
“Having assets in a taxable brokerage account, Roth accounts, as well as traditional tax-deferred accounts, gives you more flexibility to control your tax bills on a year-to-year basis,” said Benz.
What you want to avoid, if possible, is having every saved dollar in a traditional 401(k). The reason: every dollar you withdraw will be taxed at your ordinary income tax rate.
If you don’t max out your 401(k), where should you save money?
Roth accounts. Contributing to a Roth 401(k) (if your company offers it) or a Roth IRA account funded with after-tax dollars offers a few key benefits that traditional 401(k)s do not. For one, withdrawals are tax-free. That means even if you yank out $100,000 for a down payment on a home, it won’t boost your income by a single penny or increase the amount you owe to the IRS. And since the money you contribute to a Roth has already been taxed by Uncle Sam, you can withdraw your deposits (not your gains) before age 59 ½ without paying an early withdrawal penalty or taxes on your earnings.
Once your Roth has been open for five years, you have the freedom to do whatever you wish with the money you’ve put in the account without paying taxes.
“You can spend it as freely as you want when you need it,” said Kampitsis.
And with the new IRS rule mandating that high-earners in 401(k) plans that offer a Roth 401(k) invest their employer’s matching contributions into a Roth account starting in 2026, there’s an opportunity for many retirement savers to diversify their retirement savings from a tax perspective.
“If you’re a boomer who’s been doing pre-tax, pre-tax, pre-tax contributions (forever), I would try to focus on building up my Roth bucket as much as possible,” said Kampitsis.
Taxable brokerage accounts. In the age of tax-efficient exchange-traded funds (ETFs), parking money in a taxable brokerage account will allow your money to grow without major interference from big tax bills, says Benz.
“ETFs are just a terrific, tax-efficient way to invest taxable dollars,” said Benz. “These accounts can mimic the tax-sheltering features you get with your 401(k) or IRA.”
So-called “asset location” is another key plank in a financial plan looking to reduce tax drag on returns, adds T. Rowe Price’s Young.
“The tax consequences of having a taxable account are not as potentially negative as in the past,” said Young.
Another perk is that investments in taxable accounts are subject to lower capital gains tax rates, adds Kampitsis.
“Building up your brokerage bucket can be tremendously effective,” said Kampitsis. Depending on your income, you could pay as little as 0% on long-term capital gains for assets held at least one year. The highest rate is 20%. But the IRS says most Americans pay 15%.
There are many upsides to saving in brokerage accounts. There are no contribution limits. There are no age limits when it comes to tapping your money penalty-free, unlike traditional 401(k)s that require you to wait until age 59 ½ to make penalty-free withdrawals. The “rule of 55” — an IRS provision that allows workers who leave their job in or after age 55 to withdraw from a qualified plan without a 10% penalty — doesn’t apply, either.
And with layoffs on the rise, brokerage accounts can be a lifeline.
“Having that reserve of non-401(k) money is critical now more than ever,” said Kampitsis.
When it doesn’t make sense to max out your 401(k)
If it drains too much liquidity. You need money to pay the monthly bills and cover big expenses. So, having assets parked in either Roth products, taxable accounts or a cash emergency fund that you can access easily before full retirement age is critical.
When the interest on debt is higher than account earnings. If the debt you’re carrying on credit cards, personal loans, or auto loans is higher than the return you’re getting in your 401(k), it may make sense to reduce your retirement plan contributions to service the high-interest debt, says Kampitsis.
“Say you’re saving money to get a 10% return, but you’re paying 27% in interest on credit card bills and you’re only sending in the minimum payment,” said Kampitsis. “It might make sense to restructure your cash flow to accomplish both goals.”
If you plan to retire early. Many people who want to stop working before full retirement age tend to max out their 401(k)s to amass as much money as possible before they retire, says Kampitsis.
The problem is that if most of their savings are in a traditional 401(k), they likely will have to tap their old workplace retirement account and pay the 10% early-withdrawal penalty. What’s more, piling up so much money in a traditional 401(k) can add up to massive required minimum distributions (RMDs) when they turn 73.
Fund your accounts in this order
If you want to spread your retirement dollars around, the pecking order goes like this. Start with your 401(k) and contribute enough to get the match. A Roth IRA is next in line due to its more favorable withdrawal rules before age 59 ½ and tax-free withdrawals. Finally, funnel money into a taxable brokerage account to fill the third bucket.
“It’s like building blocks,” said Lisa Featherngill, national director of wealth planning at Comerica Wealth Management. “All of these accounts are going towards your retirement nest egg.”
