If you want to retire a millionaire, your 401(k) can be incredibly useful in your quest to help you reach that goal. For 2023, people under age 50 may be able to contribute up to $22,500 to their plans, while those age 50 and up have limits as high as $30,000. In 2024, those limits rise to $23,000 and $30,500 respectively.
Those high limits, combined with automatic investments direct from your paycheck, the possibility of an employer match, and the tax advantages of these plans make 401(k)s great wealth-building tools. But as awesome as using a 401(k) can be, the unfortunate truth about maxing out your 401(k) is that it may not be the best idea when considered in terms of your overall financial plan. Here are three challenges it may cause you.
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No. 1: Your money is tied up until a traditional retirement age
Until you reach age 59 and a half (55 if you're retiring that year from the company that sponsors the plan ), you will generally face a penalty on top of taxes for tapping your 401(k) money early. There are ways to get exceptions to those penalties, but they generally involve things like a minimum of five years' worth of level distributions or having to cover heavy medical expenses.
Those tax and penalty rules mean that while your 401(k) is a great place to save for retirement for once you've reached a traditional retirement age, it's a lousy place to save for your other financial priorities.
No. 2: It could cause a "tax bomb" in retirement
Traditional 401(k) plans -- ones where you contribute pre-tax dollars, but the withdrawals are taxable in retirement -- are subject to something known as Required Minimum Distributions (RMDs). Once you are old enough (currently age 73, but rising to 75 by 2033 ) and have separated from service from the 401(k) provider, you must take taxable withdrawals from your traditional 401(k).
Those withdrawals are based on your age and the balance of your account as of Dec. 31 of the previous year. If you've spent a career maxing out your traditional 401(k), that minimum distribution could get quite large. While it might sound nice to have a lot of money coming in, that money is treated as ordinary income from a tax perspective.
That extra income could do things like make more of your Social Security taxable, cause you to face higher Medicare premiums, and cause a Medicare-related surtax to be added to your other income sources. That's quite a "bomb" of extra costs, on top of the direct tax on those distributions, all from moving your own money from one of your pockets to another.
No. 3: Money you put in your 401(k) can't do anything else for you
In addition to the fact that money in your 401(k) is generally tied up until a traditional retirement age, money you're socking away in that account can't do anything else for you. At more than $22,000 per year if you max out your plan, that's a lot of money you can't put toward buying a house, taking a vacation, paying off debt, sending your kids to college, or any other life priority.
Saving for retirement is certainly important. Over-saving for retirement can easily put other very important financial, personal, and family goals out of reach or make them prohibitively expensive.
Consider the trade-offs, then invest for your future
Your retirement is likely your biggest financial goal, and your 401(k) can be an incredibly powerful tool to get you there. Yet like many tools, that power can get you into trouble if you're not careful with how you use it.
Make today the day you decide to save enough in your 401(k) to get you on track for a comfortable retirement at around a normal retirement age. Then, focus on your other key financial priorities. Once those are all on track, if you want to go back and get closer to the 401(k) max, you'll be better prepared for the risk and trade-offs you'll face.
