In the absence of dwindling pension plans, 401(k) savings plans are generally considered the most favorable retirement option for the average investor. However, unlike pensions managed by companies, 401(k) plans require personal management. Therefore, knowing about investing and developing a strategy to optimize your savings is crucial.
Think about making adequate contributions instead of the maximum. It’s important to note that there is a maximum limit for 401(k) contributions. However, many investors may not be aware of the extent of this limit. For most individuals in 2023, the maximum annual contribution stands at $22,500. Nevertheless, for those aged 50 and above, this limit increases to $30,000.
To put this into perspective, if you are 40 years old and earn $50,000 annually, contributing $22,500 equates to 45% of your annual salary. Remember, this is the maximum allowable contribution per year, and contributing more does not affect the amount of company match you receive. In most cases, employers match contributions up to 4% to 6% of your salary, albeit with some variations.
Unless you live rent-free, achieving this contribution level would be extremely challenging for individuals with such salaries. Meeting basic expenses would become arduous, let alone having any disposable income to enjoy life. Even if you live rent-free, sacrificing a substantial portion of your current income may not be necessary to build a comfortable retirement nest egg.
By simply meeting the company match, let’s say at 4%, and initiating contributions at the age of 40; you can generate approximately $526,000 in your plan by the time you reach 65, assuming a 10% average annual return and a 3% annual raise. Even with an 8% annual return, you could accumulate around $400,000 under the same circumstances.
Additionally, contributing the maximum to your plan consumes your disposable income and potentially prevents you from investing outside your 401(k) plan. Typically, the company plans to offer a limited range of funds that encompass a few market capitalization sizes and investment styles, along with company stock for those employed by public companies. They also tend to include broad retirement target date funds that become more conservative as retirement approaches.
While these options are beneficial and should be utilized, it may be advantageous to have the flexibility to enhance your returns by investing in stocks and exchange-traded funds (ETFs) beyond the limited choices in your 401(k) plan.
Furthermore, if you were to max out your contributions and later realize the need for significant investments like a down payment on a house, home repairs, or college expenses, if you withdraw your funds early, there will be a 10% penalty on top of the taxes imposed by the federal, state, and local governments on the distribution.
When maximizing contributions might be reasonable:
There are specific scenarios where maximizing your 401(k) contributions can be a sensible approach. If you or your spouse earns a high salary, such as $200,000 or more annually, contributing $22,500 per year would have a less significant impact on your day-to-day finances. Consequently, you could maximize contributions for a period of time to rapidly build your nest egg, and reduce them at any time in the event of job loss, a pay cut, or major expenses. However, it would be wise to have a substantial savings account or emergency fund to cover current expenses in case of job loss or salary reduction.
Another situation where maximizing contributions may make sense is if you are over 50 years old and have saved very little for retirement until now. Contributing $22,500, or even up to $30,000 annually if you are over 50, can help you catch up on your retirement savings. However, this may still be challenging if you have significant financial obligations like putting your children through college or dealing with other major expenses.
For most people, contributing the maximum amount to their 401(k) is not feasible and may not be the most sensible choice, especially when they have a well-thought-out long-term strategy. It is essential to balance retirement savings and meet current financial needs and goals.
Instead of solely focusing on maximizing 401(k) contributions, individuals can explore alternative investment options outside of their retirement plans. Investing in brokerage accounts, individual retirement accounts (IRAs), or other investment vehicles can provide greater flexibility and diversification.