The Unfortunate Truth About Maxing Out Your 401(k)

If you’re able to max out your 401(k) contribution, you’re in an enviable position. It’s no small feat to be able to sock away $20,500 toward your retirement this year. And while getting as much money as you can into a tax-protected retirement account is typically a good idea, it does have some downsides.

Here’s the unfortunate truth about maxing out your 401(k).

The fees can eat into your returns

The typical 401(k) plan charges a lot of fees. Those fees come in a few flavors — administrative, investment, and service fees — and they add up. The average 401(k) participant at a large company pays about 0.88% of their portfolio in fees every year.

That’s the price you’ll pay to use the tax advantages of a 401(k). Specifically, the traditional 401(k) allows you to deduct contributions from your income taxes that year and shelters the investments from capital gains taxes.

In some cases, that’s a good trade, but in others, it’s not worth it. If you can expect to keep your funds in the 401(k) for a long time, those fees will end up costing you quite a bit. And if you’re a high earner with a big gap between your earnings and spending, it’s probably worth the tax savings. You can probably keep your taxes much lower in retirement. But be sure to do the math and use some reasonable estimates to see if those fees are worth it.

You may be better off using a regular brokerage account

The alternative to maxing out your 401(k) is to use a regular brokerage account. You’ll have to pay taxes on anything you save in your regular brokerage, but it could be beneficial. That’s especially true if you don’t think the tax savings on a traditional 401(k) contribution will be substantial when you go to withdraw funds in retirement.

If you’re considering a Roth option for a 401(k), you’re more likely to be better off choosing a taxable brokerage account instead. Both use after-tax money to fund the account. While a Roth will shelter you from capital gains tax, the tax savings can be minimal. That’s especially true for a buy-and-hold investor.

If you’re saving 15% on taxes (the typical long-term capital gains tax rate), that’s great for a single year. But if you spread it out over a 40-year career, the tax savings amount to about 0.375% per year. What’s more, there are ways to mitigate the impact of capital gains taxes, so the actual tax savings could be less.

Remember, the typical 401(k) charges 0.88% in fees. When you consider you can find similar investment choices but with much lower fees in a taxable brokerage account, you’d actually be paying a premium after taxes to save in a Roth 401(k) long term.

Investing in a 401(k) effectively locks up your money until retirement age. While you can access the principal contributions from a Roth 401(k) at any time, you can’t access any of the gains without paying a penalty. Is that decreased flexibility worth the small savings (if any) you might expect long term?

Making the most of your retirement savings

The unfortunate truth about maxing out your 401(k) is that it’s not always the best financial move. While it can certainly provide tax savings, it has a cost. Those costs are fees associated with the 401(k) plan and the inflexibility of the account.

That said, everyone should contribute at least enough to obtain their employer’s matching contribution. Foregoing the match is like giving up a part of your compensation. The decision to keep contributing beyond the match requires a much deeper analysis.

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