Your 401(k) can be an incredibly powerful tool when it comes to building a comfortable nest egg for retirement. It’s so powerful, in fact, that if your goal is to retire with a modest lifestyle at a standard retirement age, it might very well be the only tool you need to use to get there.
Yet as awesome as your 401(k) plan can be, the unfortunate truth about it is that maxing out your 401(k) might not be the best use of your money overall. After all, you will have to balance multiple financial priorities throughout your working life. The restrictions and downsides when it comes to 401(k) plans mean that over-saving for your retirement in those plans could make it harder for you to reach your other financial goals.
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High limits, less money elsewhere
In 2024, people under 50 can typically contribute up to $23,000 to their 401(k) plans for the year. Those 50 and above have annual limits as high as $30,500. That’s a decent chunk of change that can potentially let you reach 401(k) millionaire status — or beyond — if you keep it up for a good portion of your career.
Yet that amount is tens of thousands of dollars each year that you won’t have available for any other financial priority. Want to buy a house? Send your kids to college? Buy a nicer car? Take a great vacation? If you’re actively maxing out your 401(k) plan, you have that much less money to put toward any of those other financial priorities.
Investing for your retirement should be a key financial priority in your life, but it shouldn’t be so all-consuming that you neglect the other things that really matter to you and your family.
It can get very expensive to tap your 401(k) money early
If you need to tap your 401(k) money before you reach a standard retirement age — typically 59 and a half — you’ll generally face a 10% penalty on top of ordinary income taxes for that withdrawal. There are exceptions to that rule, but they’re generally pretty restrictive.
Your 401(k) money is intended to be there for your retirement. Those penalties are there to deter you from tapping your retirement money early. While they are pretty effective at doing that, they also mean that once you’ve put money into your 401(k), it’s expensive to get it out before you’re retired.
Too much of a good thing can cause troubles
In addition to those restrictions and trade-offs during your working years, having too much money in a Traditional-style 401(k) can cause you headaches once you retire. Even once you qualify for penalty-free withdrawals, money you take out of a Traditional 401(k) is treated as ordinary income and subject to regular income taxes.
That can be fine if you’re just withdrawing what you need to cover modest retirement expenses. The problem comes into play once you’re subject to Required Minimum Distributions (RMDs). Once you reach age 73 — rising to age 75 by 2033 — those RMDs mean you must withdraw money from your Traditional 401(k) plan each year based on your age and account balance.
If you max out your Traditional 401(k) contributions throughout your career, there’s a decent chance you will end up with a multi-million dollar nest egg in it by the time you need to take those RMDs. This causes trouble not just because of the direct income taxes on your withdrawals, but also due to the knock-on effects that drives on the rest of your financial picture.
Your Social Security benefit becomes taxable based on your combined income. That number is your adjusted gross income, plus any non-taxable interest income you earn, plus half your Social Security benefit. Your RMD is included in your adjusted gross income, which means a significant RMD can make more of your Social Security taxable — and taxable at a higher marginal rate.
In addition, Medicare Parts B and D use your income level to determine your monthly premium amount. With a higher income driven by those RMDs, your Medicare Part B and D premiums can be as much as $675 per month higher than the standard premium levels.
Add together the direct higher income taxes, the higher taxes on your Social Security benefits, and the higher Medicare Part B and Part D premiums, and the total cost to you can be substantial. Those costs can be minimized by either using Roth-style retirement accounts (which are not subject to RMDs in the original account owner’s lifetime) or ordinary investment accounts.
Find a good balance today
Your 401(k) can be a tremendously powerful tool in your retirement planning arsenal. Like many tools, though, over-using it can cause you problems down the road. Make today the day you put your plans in place to find a good balance between your 401(k) and your other financial priorities. As you find yourself closer to meeting more of your overall financial goals, you’ll be glad you did.
Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
