“Max out your 401(k)” is one of the most common pieces of financial advice.
For many people, it is good advice. A 401(k) offers tax advantages, automated investing, potential employer matching contributions, and a convenient way to build long-term wealth.
But maximizing your contribution is not automatically the best use of every available dollar.
The problem is not saving too much. It is putting too much of your savings in an account designed primarily for retirement while neglecting the financial goals that come before it.
Consider a couple earning $200,000 per year. After capturing their full employer matches, they decide to contribute an additional $20,000 to their traditional 401(k)s.
Assuming a 22% federal marginal tax rate, that contribution could reduce their current federal income taxes by approximately $4,400. That is a meaningful benefit.
But suppose they plan to purchase a home in three years and have not built adequate savings outside their retirement accounts. When the time comes, they are $20,000 short of the cash needed for the purchase.
Because the money is inside their 401(k)s, their options may be limited. They could delay the purchase, reduce their down payment, borrow from the plan if permitted, or take an early distribution. A taxable early distribution could also be subject to an additional 10% federal tax unless an exception applies.
Alternatively, they might finance the $20,000 through a personal loan or other borrowing. At an 8% interest rate over five years, the loan would cost roughly $4,300 in interest.
In other words, they may have saved approximately $4,400 in taxes by making the additional contribution—only to incur a similar amount in borrowing costs because they no longer had access to the cash.
The tax savings were visible. The loss of flexibility was not.
There can also be a longer-term cost to accumulating nearly all of your retirement wealth in pre-tax accounts. Traditional 401(k) withdrawals are generally taxable, and these accounts may eventually become subject to required minimum distributions.
Those distributions can reduce your control over taxable income in retirement. Depending on your circumstances, additional income may cause more of your Social Security benefits to become taxable or contribute to higher income-related Medicare premiums.
None of this means you should stop contributing to your 401(k). The employer match alone often makes contributing an obvious first step. For many households, maximizing the plan may still be appropriate.
The better question is not simply, “How much am I allowed to contribute?”
It is, “Where will my next dollar be most valuable?”
After capturing the match, that dollar might belong in the 401(k). But it might also be better used to build an emergency fund, pay down expensive debt, fund an HSA or Roth account, or create a taxable investment account for goals that will occur before retirement.
A strong savings strategy is not about maximizing one account. It is about coordinating your accounts so that you have the right combination of growth, tax efficiency, and flexibility.
At Hanover Advisors, we help clients determine not only how much they should save, but where those savings should go based on the life they are planning, both now and in retirement.