What's the Unfortunate Truth About Maxing Out Your 401(k)?

Key Points

• While a 401(k) is designed to help you save for retirement, maxing out your plan is not always the right move.

• There's no rule against contributing only a portion of your income to a 401(k) and investing the rest elsewhere.

• You'll find a wider range of investment options outside your 401(k) plan.

• The $23,760 Social Security bonus most retirees completely overlook ›

For anyone who's ever crashed into a financial brick wall and had to start all over again, few financial vehicles are more useful than a 401(k), particularly when that 401(k) has vested.

That said, no retirement plan is perfect, and maxing out your 401(k) is not always the wisest move. Here's why.

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Reduced liquidity

You're not alone if you feel a little panicked when things go south. A study by the financial services company Empower found that only 34% of Americans are confident they can handle an emergency financial situation. Another 37% said they can't afford to pay an emergency expense over $400.

Unless you lose or leave your job at age 55 or older, you generally can't withdraw money from your 401(k) until you're at least 59 1/2 without paying a 10% penalty. And if maxing out your 401(k) means skimping on building an emergency account, that can be a problem when an emergency arises.

Opportunity cost

Let's say you're the kind of person who checks the financial news first thing every morning. You enjoy learning about emerging markets and have developed a strategy for picking (mostly) winners. If you put all your available funds into a 401(k), you could miss out on other investment opportunities -- moves that could yield higher returns.

For example, you may want to buy a particular stock, but your 401(k) doesn't offer it as an option. Or you may be unable to invest in an attractive business because your money is tied up. Although maxing out your 401(k) provides benefits, it can also cost you other opportunities.

Limited options

It's no secret that 401(k) plans often offer limited investment options, especially compared to individual retirement accounts (IRAs) and other investment accounts. And because your 401(k) is likely employer-sponsored, you have very little say over how much you pay in fees. When you go out on your own to open an IRA or other investment account, you can shop around, finding fees that fit your goals.

Market risks

Nearly all investments are subject to market fluctuations, and if your 401(k) is heavily invested in stocks, you could face significant losses during downturns in the market. Historically, all market downturns have been followed by recovery (and growth), but there are no guarantees. If you lie awake at night worrying about your retirement fund, maxing out your 401(k) could leave you with more sleepless nights.

Tax implications

Most contributions to 401(k)s are made pretax, meaning you don't pay taxes on your contributions until you withdraw them in retirement. At that point, both contributions and earnings are taxed as ordinary income. Depending on your situation, you may have a higher income in retirement than you had during your working years. If you believe that may be the case, ask your plan administrator if your plan allows after-tax contributions.

Conversely, you may consider contributing only as much as your employer offers to match, and invest the rest in after-tax investment vehicles like those available via brokerage accounts.

401(k)s can help everyday people become millionaires, but maxing one out isn't right for everyone. If you're faithfully contributing to a 401(k), make it a point to build an emergency savings account and consider working with a financial planner to determine the best tax strategy for you.

Most importantly, keep investing.

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