Should you max out your 401(k)? Pros, cons & alternatives

A 401(k) can be a great way to save for retirement, and the more money you contribute, the more savings you may have when you retire. But should you max out your 401(k) contributions every year?

While maxing out your 401(k) has benefits, it also leaves you less money for other financial goals. The limits themselves can be enough to deter some savers.

• In 2023, the maximum contribution is $22,500 with a catch-up provision of $7,500 for people over age 50.
• For 2024, the maximum contribution is $23,000 with a catch-up provision of $7,500.

And while maxing out your 401(k) can make sense in some situations, it may not be the right choice for everyone or every year. Consider these factors first.

401(k)s give you a tax-advantaged way to save and invest for retirement. Both traditional and Roth 401(k)s allow you to contribute a portion of your income from each paycheck, and your employer may provide matching contributions as well. You can choose how you want to invest your contributions from among your plan's fund options.

• Contributions to a traditional 401(k) are taken from your paycheck pre-tax, and your investments grow tax-deferred. Withdrawals are included in your taxable income.
• Roth 401(k) contributions are taken from your paycheck after-tax, but your investments grow tax-deferred. Qualified withdrawals aren't taxed. However, any employer matching contributions go into a traditional account.

401(k)s have two different contribution limits: your own contribution limit and the overall contribution limit, which is the combined total of contributions from you and your employer—also known as the annual additions limit. Keep both limits in mind, but when most people talk about maxing out a 401(k), they're referring to your personal contributions.

The plan administrator tracks the amount of your contribution to help you avoid exceeding these limits. The penalty for over-contributing to 401(k) accounts is unnecessary taxes unless you quickly identify and correct your mistake.

Contributing the maximum amount to your 401(k) can have several benefits, including tax advantages, increased financial security and investment growth.

The more you contribute to your 401(k), the more you can tap into the tax advantages. You can decrease your taxable income and defer taxes on investment growth.

A larger savings balance offers more financial security than a smaller one. It doesn't take long to build a substantial amount of savings if you max out your 401(k) each year, making it easier to reach your retirement goals.

The more you contribute to your 401(k), the more compound growth you can accumulate. To see how much difference your contributions can make, compare the growth on the maximum $22,500 contribution to what would happen if you contributed half of that ($11,250). Assuming 8% annual growth, after 10 years:

• You'd have about $326,000 if you contribute the max each year.
• You'd have $163,000 if you contributed $11,250 per year.

The difference between these two is that you contribute $112,500 more over 10 years but end up with $163,000 more in your account.¹

Despite the benefits, it may not make sense to max out your 401(k) contribution. You may have other goals you want to prioritize and cannot afford to save for both, or you may not need to save that much for retirement. Even if you want to save a significant amount, maxing out your 401(k) may not be the most tax-efficient way.

Although it's important, retirement may not be your only financial goal. You may have kids that need to pay for college, a new car to buy or planned home upgrades like paving a driveway.

You could max out your 401(k) while saving for these other goals, but you may need to prioritize where you give the most attention. If you contribute all you can to a 401(k), you may not have enough room in your budget for the other plans you envision for your family.

Considering the high annual contribution limit, you may not need to save much more to build a sufficient nest egg for your desired retirement lifestyle. A good rule of thumb is to save 15% of your salary, and for some people that could be enough. If you're already on track to save enough for retirement, it won't make sense for you to continue to maximize your 401(k) savings. You can use any extra money for other priorities, such as volunteering or taking more time off work to spend with family.

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Although 401(k)s provide excellent tax benefits, you may not want to put all of your savings into one. Tax diversification can be as important as investment diversification.²

Instead of putting all of your money into a 401(k), it may make sense to also contribute to IRAs and taxable brokerage accounts. Since each of these is subject to different taxation and distribution rules, having money in each could spread out your tax liability more evenly over time.

If you have the ability to save more, consider your other goals and retirement savings options in addition to contributing the maximum amount to a 401(k). These may include:

• Keeping extra cash reserves on hand as an emergency fund to be prepared for short-term needs.
• Paying down debts to free up cash flow. Credit cards, car loans and mortgages can take up a significant part of your budget.
• Setting up a fund to help your kids or grandkids get a good start on paying for college or putting a down payment on a home.
• Contributing to a local charity or civic organizations that support activities closest to your heart.
• Paying the tax bill on Roth conversions if you already have a significant tax-deferred savings balance in a traditional 401(k) or IRA.³

Although contributing the maximum amount to a 401(k) is a great way to stay on track for retirement, it isn't always the best option. Consider the full picture of your financial future before you max it out.

As you plan how to spend your savings for a bountiful retirement or on meaningful milestones for your family, a Thrivent financial advisor can help you decide the best route for your money.