Saving for retirement in a 401(k) is one of the most effective ways to build up a nest egg. But with the maximum contribution limit at a considerable $22,500 for those under 50 and $30,000 for savers age 50 or older, should you be maxing it out?

If you are saving in a Roth account, contributing the max allows you to get to your goal sooner and take advantage of the power of compounding for longer before you need the money. If you are saving in a traditional 401(k), a 403(b), or 457 plan, you receive that benefit and the ability to contribute with pre-tax dollars. This lowers your taxable income for the year the contribution is made and may save you money on taxes.

But there’s more to consider than just the investing and tax benefits. You want to consider your 401(k) contributions in the context of the plan’s structure, the employer match, and your own situation.

 

The 401(k) Basics

First, let’s determine a minimum contribution to a Roth or traditional 401(k). If your employer offers to match your contribution, getting the most out of this benefit should be your goal. The match is usually capped at a percentage of your salary, for example, 6%.

The formula is determined by your employer, and it may be a dollar-for-dollar match, or a percentage of your contribution. Or it could be a combination of the two. From the employer’s perspective, matching allows them to provide you with a benefit and incentivizes you to save for your retirement. It doesn’t count against your own contributions.
You want to figure out the amount you need to contribute to get all employer matching funds allowed. Otherwise, you’re leaving money on the table. This is the first minimum hurdle.
Once you’ve met the match, how much more should you contribute? Your 401(k) may offer an automatic increase feature that pushes your percentage up every year. This can be a good idea to help you save money over time, and it’s usually capped at a specific percentage, such as 10%.

Another general rule is to contribute 15% of your salary. As your salary increases, you may max out your contribution before you get to 15% of your salary. Whether or not that’s the case, should you be maxing out contributions?

 

Are There Better Uses for the Funds?

Even if your salary is high enough that maxing out contributions is not a burden, there are some boxes to check first.
Is your “rainy day fund” fully funded? You may need more than you think, especially if your salary or lifestyle has changed. You should have enough saved to cover either 3-6 months of your salary or 3- 6 months of your expenses. Drawing money from a 401(k) if you need funds is expensive in terms of penalties and taxes, and it’s generally a better idea to put money aside in advance than have to withdraw from your retirement funds.

Have you considered a Health Savings Account? HSAs allow you to put money aside for health care costs. Diverting some funds to an HSA may make sense, as they are “triple tax-advantaged,” meaning that you contribute with pre-tax dollars, the funds grow tax-free, and they are not taxed when you use them for qualified health care expenses. This is an advantage over funds in a traditional 401(k) or similar account, which are taxed upon withdrawal.

For 2023, the amount you can contribute to an HSA is $3,850 for an individual and $7,750 for family coverage. These accounts also have a catch-provision, allowing those 55 and older to contribute an additional $1,000. It is necessary to select a high-deductible health care plan to be eligible to save in a health savings account.

 

When Should You Max Out?

If you are in a high tax bracket, contributing to a 401(k) now and withdrawing the money in retirement, when your tax bracket may be lower, can make sense. However, taxes tend to increase over time. Especially as you get close to retirement, beginning to plan not just savings but the tax strategies you will implement to keep your taxes low once you’ve retired is critical. Having an overall picture of how much you need for income and where you will draw funds from can help you keep taxes low and may provide clarity on 401(k) contributions now.

 

Your Goals, Plans, and Lifestyle Should Be Considered

Creating a retirement nest egg is just one piece of the retirement puzzle. Are there goals that are more important to you now? When do you want to retire? What does that retirement look like? If you want to buy an investment property at the beach that you’ll move into once you retire, that may be more important.
You also want to consider your entire investment strategy. Retirement plan investment options may be limited, and you may prefer setting up a taxable account where you have more choices that may help you get to your goal, such as alternative investments. If you have a concentrated stock position from your employer’s stock, you may want to develop a strategy to mitigate the concentration risk away from equities. Or, if you have the opportunity to buy and exercise options, diverting funds to that use can be a powerful retirement savings builder.

The Bottom Line

Having a plan for retirement is critical, and saving as much as possible in a Roth or traditional 401(k) is usually the foundation. But as you move along your financial journey, it’s a good idea to create a bigger-picture plan that takes more into account so you can decide what’s right for you.

1. Bankrate Financial Independence Survey, March 2023.