Does it make sense to max out my 401k?

This is a common question that I’ve heard even more frequently this year.

Some background – The limit on individual contributions to a 401k plan in 2020 is $19,500.  You can contribute an additional $6500 if you are at least 50 years old by the end of the year.

There are some benefits to contributing to your employer’s 401k plan.  The best-known benefit is that the contributions to a traditional 401k are pre-tax – in other words, the money you contribute this year will not be subject to income tax this year.  And, the employer may match some or all of your contribution which is essentially free money.

There are also some drawbacks to contributing to your employer’s 401k plan.  First, in exchange for the tax deferral on your contribution, you generally can’t withdraw the funds from the plan before age 59 ½ without a penalty.  Even after age 59 ½, some plans don’t let you withdraw funds until you leave the employer. The number of investment options in the plan may be relatively small and not what you would otherwise choose as investment funds.  And, you can’t easily use the money in your 401k plan for other expenses that may come up before you retire.

Things have changed

Back in 1981 when 401k plans were originally devised, income tax rates were much higher.  The theory was that a worker could contribute pre-tax money to their retirement fund during their working years and then pay the tax on the funds as they withdrew the contributions and any investment earnings during retirement.  The distributions would be taxed at the rate for ordinary income.  There would be no tax drag on the retirement investment account from the time that the funds were contributed until they were withdrawn.  Another key part of the theory was that the household income would be less during retirement and therefore the retiree would be in a lower tax bracket.

However, things have changed since 1981.  Notably, personal income tax rates are lower now so the tax savings on contributions is not as great.  And, today many people do not see the reduction in income at retirement that was accepted as a general rule in the 80’s so therefore, they may not be in a lower tax bracket.  And, tax brackets may change simply due to legislation rather than income levels.

Does this mean I shouldn’t participate in my 401k?

Not necessarily.  First, free money is free money.  If your employer offers a match, I suggest you consider contributing at least enough to get the maximum match from your employer.

After the free money, the question becomes more complicated.

If your employer’s retirement plan offers a Roth component you may want to consider making Roth contributions.  With Roth contributions, you don’t get a deduction for your contribution in the current year.  But, the contribution and any growth can be withdrawn tax-free in retirement.  If you believe that you may be in a higher tax bracket during retirement, a Roth contribution may be the way to go.  Remember, you will have Required Minimum Distributions from your traditional IRAs and your 401ks.  You will be required to take these distributions starting in the year that you turn 72 (70 ½ if you turned 70 ½ before January 2020) whether you need the funds or not.  In some cases, this can push you into a higher tax bracket.

Also, at retirement or sometime after you separate from your employer, you could roll over the Roth component of a 401k into a Roth IRA.  Required Minimum Distributions do apply to Roth 401k accounts but do not apply to Roth IRA accounts.  You could leave the funds in your Roth IRA to continue to take advantage of tax-free potential investment returns.  And, you can withdraw those funds when you want to withdraw them rather than being forced to withdraw a portion annually.

Yes, you can accomplish the same thing by contributing annually to a Roth IRA.  However, the annual limit on contributions to an IRA is only $6,000, or $7,000 if you’re 50 or older.  The limit on Roth 401k contributions is part of the limit on total 401k contributions.  You could choose to contribute up to the $19,500 maximum ($26,000 if you’re 50 or older) to the Roth component of your 401k plan.  And the ability to contribute directly to a Roth IRA is limited by income – it starts phasing out at $124,000 in MAGI for single filers and is completely phased out at $139,000 and for Married Filing Jointly households the phaseout range is $196,000 to $206,000.  The ability to contribute to a Roth 401k is not phased out based on income*.

Access to investments

In some cases, you may gain access to investments in your 401k that you would not have as an individual investor.  Sometimes this may be a share class of a mutual fund and in other cases it may be access to funds from a particular investment manager.  There are times when you could access investments that are suitable and appropriate for your needs at a lower cost in your 401k account than you can elsewhere.  This really depends on your employer and how much they subsidize expenses related to the plan.

Income (tax) management

There are times when you may want to contribute to your 401k plan simply to lower your tax bill for the current year.  For instance, if you’re married and filing jointly and you expect your adjusted gross income to be $165,000, you will be $5,000 into the phaseout range for the American Opportunity Tax Credit, a valuable credit for those who have paid qualified college expenses.  By contributing at least $5,000 to your traditional 401k plan, you have saved for your own retirement and may have qualified for the full tax credit.  Of course, this requires some advance planning and you’ll need to have room in your cash flow to accommodate the contribution.

As usual, the answer is “It depends”

Whether it makes sense to contribute the maximum to your 401k or contribute at all depends on your financial situation and your goals.  If you have access to a Roth 401k, it definitely makes sense to evaluate how having Roth funds gives you more options in retirement.  And, if your employer wants to help you save for retirement by matching your contributions, you should see what you can do to take advantage of that free money.  You should also make sure you understand the features and provisions of your 401k plan so you know when you can make elections, how often you can change them, and what the investments and fees associated with the plan are.

And, you’ll need to re-evaluate your decisions any time the playing field or the goal changes.  If we have another tax package that impacts how 401k plans function or otherwise has an effect on your tax situation, you’ll want to see if your current strategy still makes sense.  If you change employers or the provisions of your current plan change, you will also want to see if you need to make changes to your 401k plan contributions.  And, if you change your timing or your definition of retirement, you’ll want to revisit how your retirement funds fit into your plans.

*However, your employer may limit the amount you can contribute to your 401k plan if you are a Highly Compensated Employee.